There has been a lot of discussion regarding the probability of the possibilities of Inflation and Deflation. Before we dive into the evidence I would like to set the context today.
Core Inflation is a measure of inflation (bandied about commonly) that excludes food and energy. For the very precise reason that it excludes some of the largest non-discretionary spend items, I consider them useless. The YoY change in Consumer Price Inflation index (adjusted for all accounting gimmicks) is in excess of 10%!! True CPI
In other words there is Inflation today.
The case for deflation now…
The recession in the United States is what economists call a Balance Sheet Recession. The consumer is over –leveraged and is now deleveraging.
After the Sep’08 crash the Fed launched QE. QE was supposed to buy back distressed assets to ensure that the prices of these assets did not go into a free fall. The operation created reserves (physical cash in banks). Theoretically this is cash that can be used by the fractional reserve banking system to generate credit. By virtue of ensuring price stability they also prevented erosion of capital (equity capital) in the banks which would have otherwise suffered mark-to-market losses.
However saving the middle-man (Banks) does not ensure the transmission of monies to the real economy. Banks cannot indulge in capex programs. Consumers have to consume, for companies to withdraw loans for expansion.
The manifestation of this is the money supply M3. This is no longer reported by the Fed. The M3 figure that has been derived (from its constituent components) clearly shows a contraction in supply for a short period. True Money Supply
Furthermore the promise of low yields by Ben Bernanke has flattened the yield curve which can apparently destroy credit creation. Ben destroys credit
Given all the above evidence why is there inflation today? Why is there a bull-market in commodities?
A hypothesis for this is that Banks with reserves and very little equity capital cannot indulge in proprietary trading because it would cause an explosion in their risk weighted assets (RWA).The easier way to make money on the reserves would be Margin-lending. To leverage a bet on the commodity market, with the underlying commodity as collateral is a safer way of lending. This could have galvanized a bubble. Data clearly indicates an explosion in margin lending. Margin Lending explosion
In summary we ‘should’ be tempted to agree that since Money supply has not really ballooned and that the commodity up-tick is merely a flash in the pan – All arrows are pointing to deflation.
But..
Deflation is a dream scenario for creditors. It means that the lenders will be paid back in more valuable dollars. It would not be a rational response for a country that has its debts denominated in its own (printable) currency. Inflation is always the easier way out.
The Fed has printed money ($ 2 Trillion ) with the goal of stimulating the economy. It would be reasonable to believe that they were hoping for inflation to help expectations of growth.
It’s like a man being given a bazooka and the mandate to destroy a truck. He held the bazooka facing backwards having the unintended consequence of blowing the house behind him. Now I would expect him to turn the bazooka around for a fresh try.
The Fed did not point the bazooka (printing press) in the right direction. I would imagine it is only a matter of time before they re-align.
Key triggers..
Some lessons to be learnt from the Wiemar inflation are that speculation by foreign investors can be a key component of driving hyperinflation
“What actually drove the wartime inflation into hyperinflation, said Schacht, was speculation by foreign investors, who would bet on the mark’s decreasing value by selling it short.” –– From Wiemar with Love
While dollar denominated assets are still being viewed as a safe haven, if this trend reverses and investors lose faith in the dollar or the capacity of US to pay its debts then there can be a sharp devaluation of the dollar.
The US is a net importer and this can cause a serious rise in prices. This will also be followed by a rise in interest payments; the only way to pay back this increased interest burden is to print fresh money. Debt monetization will lead to a weaker dollar and further fuel a cost pushed inflation.
This largely boils down to a question of how long the markets will repose faith in the Dollar.