The Case For Deflation?
No matter where one is standing in the ongoing inflation vs. deflation debate, one should always listen to the other side’s arguments. That is why this week’s topic will be deflation.
Before I want to discuss today’s arguments for a continuation of the current deflationary economic environment, let us look at the theory at first.
Nowadays the term ‘deflation’ is used synonymously for price deflation, a general decrease of prices.
Basically, falling prices can have two possible causes: either the fall in prices is caused by a falling supply of money in a currency area or by an increase in productivity, which is a rise in the quantity of goods produced. In the second case, price deflation is expressing a rise in the standard of living of the population and therefore something positive.
However, if the gold standard would still be in play, a current account deficit would lead to an outflow of gold to a country with a current account surplus. While the money supply is falling in the one country, the money supply in the other country is rising.
As a result, prices (expressed in gold) in country A, which has a negative current account balance, should fall while it should rise in country B. In theory that is why current account imbalances should withdraw over time, because falling prices in country A should make it more attractive for country B to buy goods from country A.
While this system was ended after World War II and replaced by the Bretton-Woods System, the mechanism stayed the same for as long as the dollar was considered to be as good as gold, until President Nixon closed the gold window.
Nowadays, US dollars are used for a vast majority of international trade and the Federal Reserve, in theory, can print as many dollars as they want. This is one cause why the US has been able to run a current account deficit for more than 40 years now, which means that they have been importing more goods and services as the export. The world produces goods and exchanges them for US dollars.
In our example, those dollars can be used by country B to buy products from another country C, which is accepting US dollars for international trade. Goods flow to country B and dollars flow to country C. If the dollars do not return to the United States, they are staying within the global Eurodollar system and therefore prices in the US will be lower than they would have been if the money flows back to the US.
Contrariwise, if country C is using the dollars that they have received from country B to buy US treasuries, the money flows back to the United States as Country C is lending it to the US government. If the US government is spending this money into the real economy, prices will adjust upwards again.
However, foreign dollar holders can buy other assets than US treasuries, for example US stocks or real estate. If they do so, this will cause a rise in prices in those assets while the demand for consumption goods is lower than it would be if the money had flown back into the real economy.
As asset prices rise, holders of these assets are able to get more access to credit and further raises demand for goods and services (or assets) that are bought with the new money (that was created out of thin air) and leads to further price increases.
Recently, this was exactly what happened. Business bought back stocks or invested into real estate and then levered up further on their rise in paper wealth. Before 2008 it was mainly the housing market where the money went while, after the bust of the housing bubble in 2008, the money mostly has gone into bonds and stocks. A while ago, housing prices again have started to explode to the upside.
To keep the system going, more and more money must be injected into the system because a fall in asset prices would lead to a chain reaction.
Whenever the economic outlook is worsening, as in 08 or in 2020, asset prices collapse, leveraged market participants have to default and people lose their jobs or have to agree on lower wages and as a result it becomes harder for them to fulfil their obligations. All these things cause troubles within the banking sector because they are bearing the risk of a default of creditors.
The reason and harshness of this deflationary shock is directly correlated to the previous, inflationary monetary policy. That is why central bank and fiscal policy always have to become more expansive and never are able to return to pre-crisis levels.
That is why governments and central banks are in fear of deflation while they welcome (moderate) price inflation. The way the consumer price index is calculated plays into their hands as well.
Although people feel that prices rise faster than expressed in the CPI numbers, economists and central bankers always can refer to moderate increases in the CPI.
Additionally, another effect comes into play: due to the experienced price increases more and more retail investors pour into asset markets. This is decelerating price inflation in consumer goods further, although one has to point out that there are lots of other influencing factors.
All these imbalances are a result of expansionary monetary policy and increase the risks of a bigger fall in asset prices in case of an exogenous shock. Nevertheless, one has to admit that central banks have managed all those risks extraordinary for the last decade.
However, central bankers can be thankful that the commercial banking sector has been so hesitant to hand out loans into the real economy for all those years. This kept money within asset markets and therefore diminished consumer price inflation.
With reference to the fast development of Covid-vaccines, investors jumped onto the reflation trade. Many politicians already called out a revival of the Roaring Twenties, induced by low interest rates and huge government spending.
Meanwhile, the Federal Reserve is denying that inflation is here to stay and point out that inflation is mainly rising because of base effects. However, because of that, so they say, inflation will be transitory and remain subdued over the medium term.
Will the deflationary environment continue? Proponents are pointing out that the US treasury market is strongly supporting their standpoint. After they nearly reached 1.80 % back in March, they are back at around 1.50 % now.
If the Fed starts to scale back on asset purchases, one would assume that this will lead to a rise in yields because demand for US treasuries on the secondary market is falling. However, when Ben Bernanke announced tapering back in 2013, as soon as the Fed actually started to taper, the opposite happened. In midst of 2014 the Fed cut back on their purchases (and later stopped) and US 10y yields started to fall. The following chart shows the YoY-change of the Fed’s balance sheet vs. the 10y treasury yield:
Yields started to rise again when Janet Yellen started to raise rates in late 2015. If one looks at the yearly change in US 10y yields vs. the Fed’s balance sheet, the picture gets more obvious (Note: The Fed funds rate does not fit into the metric of the left- or right-handed side):
This suggests that the market is expecting a similar scenario to the last tapering, namely that the Fed will start to taper, inflation will peak and then quickly will fall back below the Fed’s 2 % target.
This view is shared by Jeff Snider, Head of Research at Alhambra Investments, and economist David Rosenberg, who expect that inflation indeed will be transitory.
David rejects the objection that the Biden administration will implement an MMT-environment: In a recent Hedgeye talk with Hedgeye CEO Keith McCullough, he answered that all the MMT-talking is just talking without any substance. According to his view, MMT will not become reality.
His point of view is that the situation is comparable to the early 2010s and, as back then, the deflationary economic environment will continue because of weak economic growth, the deflationary effect of rising debt and because of an aging population.
Further he (and Jeff as well) holds the opinion that the recent pick up in commodity prices is already starting to normalize and expects this trend to continue as soon as the supply side is coming back. Both point out that the current data is accompanied by lot of noise and therefore they say that one should be cautious to interpret the recent pick up in inflationary measures as a shift to an inflationary environment. Although both expect that inflation is here to stay for the rest of the year, the expect that it will fade out afterwards.
David rejects the conclusion, that rents will pick up strong because housing prices have already risen. Contrariwise, he argued that one should be careful what one wishes for, because last time when housing caused a pick-up in inflation, it resulted in a deflationary crash.
Finally, he pointed out that all of his clients are asking him because of inflation fears and therefore he considers it an overcrowded trade (although the numbers suggest otherwise, as Keith correctly pointed out). David even rejects that wages will drive up inflation as, according to his view, the situation will change when all the extra benefits end.
Jeff Snider (also in an interview with Hedgeye) points out two more points that I have discussed for several times here: Firstly, the Fed cannot create inflation with QE, because the Fed does print bank reserves, not dollars.
Secondly, the Fed can hardly influence the quantity of money in the real economy because in the current monetary system it is up to the commercial banks expand broad money through credit expansion. It is the commercial banks who simply do not lend enough. For the commercial banks, the Fed’s QE is only an asset swap, where the bond on the commercial bank’s balance sheet is exchanged for bank reserves.
According to Jeff, banks do not lend because the risk spread is so low that it is not worth the risk. Although he is surprised how hot inflation has been running recently, he merely considers it as price-deviations because of supply and demand imbalances, not real inflation.
Thus, Jeff points out that the market is skeptical about inflation because there is so much noise in the data. When he was asked about China, he said that he is not convinced that China has stopped buying foreign exchange reserves (the position on the PBoC's balance sheet has remained flat for almost two years now) and thinks that this looks engineered. According to him, the world is short of dollars and therefore, he points out, it is deflation that is coming, not inflation.
Although I think that both, David and Jeff, are making some very good arguments, but I do not think that we will return to the deflationary environment of pre-2020 because of a variety of differences to post 2008.
For example, I disagree that MMT is just talking and that a republican senate will stop more stimulus and infrastructure bills from happening. MMT will become reality and maybe it already has. Broad money supply has expanded a lot more than it did back in 2008, mainly because of all the stimulus.
Further I take Biden very seriously when he talks about the administration’s goal to push wages higher and especially that Biden will do even more fiscally if the results are not as expected. However, this will not lead to more sustainable growth but only to more malinvestment and more government debt.
The Fed will not have another choice at some point than to monetize the debt and to inflate it away. Although it may fight the rise in interest rates (via YCC?), but this will put further pressure on inflation. Until the next deflationary crash is happening, inflation will not return to pre-crisis levels, at least in my opinion. But until then, the hoarding of (relatively) limited assets will continue…
Have a great weekend!
Fabian Wintersberger
Before I want to discuss today’s arguments for a continuation of the current deflationary economic environment, let us look at the theory at first.
Nowadays the term ‘deflation’ is used synonymously for price deflation, a general decrease of prices.
Basically, falling prices can have two possible causes: either the fall in prices is caused by a falling supply of money in a currency area or by an increase in productivity, which is a rise in the quantity of goods produced. In the second case, price deflation is expressing a rise in the standard of living of the population and therefore something positive.
However, if the gold standard would still be in play, a current account deficit would lead to an outflow of gold to a country with a current account surplus. While the money supply is falling in the one country, the money supply in the other country is rising.
As a result, prices (expressed in gold) in country A, which has a negative current account balance, should fall while it should rise in country B. In theory that is why current account imbalances should withdraw over time, because falling prices in country A should make it more attractive for country B to buy goods from country A.
While this system was ended after World War II and replaced by the Bretton-Woods System, the mechanism stayed the same for as long as the dollar was considered to be as good as gold, until President Nixon closed the gold window.
Nowadays, US dollars are used for a vast majority of international trade and the Federal Reserve, in theory, can print as many dollars as they want. This is one cause why the US has been able to run a current account deficit for more than 40 years now, which means that they have been importing more goods and services as the export. The world produces goods and exchanges them for US dollars.
In our example, those dollars can be used by country B to buy products from another country C, which is accepting US dollars for international trade. Goods flow to country B and dollars flow to country C. If the dollars do not return to the United States, they are staying within the global Eurodollar system and therefore prices in the US will be lower than they would have been if the money flows back to the US.
Contrariwise, if country C is using the dollars that they have received from country B to buy US treasuries, the money flows back to the United States as Country C is lending it to the US government. If the US government is spending this money into the real economy, prices will adjust upwards again.
However, foreign dollar holders can buy other assets than US treasuries, for example US stocks or real estate. If they do so, this will cause a rise in prices in those assets while the demand for consumption goods is lower than it would be if the money had flown back into the real economy.
As asset prices rise, holders of these assets are able to get more access to credit and further raises demand for goods and services (or assets) that are bought with the new money (that was created out of thin air) and leads to further price increases.
Recently, this was exactly what happened. Business bought back stocks or invested into real estate and then levered up further on their rise in paper wealth. Before 2008 it was mainly the housing market where the money went while, after the bust of the housing bubble in 2008, the money mostly has gone into bonds and stocks. A while ago, housing prices again have started to explode to the upside.
To keep the system going, more and more money must be injected into the system because a fall in asset prices would lead to a chain reaction.
Whenever the economic outlook is worsening, as in 08 or in 2020, asset prices collapse, leveraged market participants have to default and people lose their jobs or have to agree on lower wages and as a result it becomes harder for them to fulfil their obligations. All these things cause troubles within the banking sector because they are bearing the risk of a default of creditors.
The reason and harshness of this deflationary shock is directly correlated to the previous, inflationary monetary policy. That is why central bank and fiscal policy always have to become more expansive and never are able to return to pre-crisis levels.
That is why governments and central banks are in fear of deflation while they welcome (moderate) price inflation. The way the consumer price index is calculated plays into their hands as well.
Although people feel that prices rise faster than expressed in the CPI numbers, economists and central bankers always can refer to moderate increases in the CPI.
Additionally, another effect comes into play: due to the experienced price increases more and more retail investors pour into asset markets. This is decelerating price inflation in consumer goods further, although one has to point out that there are lots of other influencing factors.
All these imbalances are a result of expansionary monetary policy and increase the risks of a bigger fall in asset prices in case of an exogenous shock. Nevertheless, one has to admit that central banks have managed all those risks extraordinary for the last decade.
However, central bankers can be thankful that the commercial banking sector has been so hesitant to hand out loans into the real economy for all those years. This kept money within asset markets and therefore diminished consumer price inflation.
With reference to the fast development of Covid-vaccines, investors jumped onto the reflation trade. Many politicians already called out a revival of the Roaring Twenties, induced by low interest rates and huge government spending.
Meanwhile, the Federal Reserve is denying that inflation is here to stay and point out that inflation is mainly rising because of base effects. However, because of that, so they say, inflation will be transitory and remain subdued over the medium term.
Will the deflationary environment continue? Proponents are pointing out that the US treasury market is strongly supporting their standpoint. After they nearly reached 1.80 % back in March, they are back at around 1.50 % now.
If the Fed starts to scale back on asset purchases, one would assume that this will lead to a rise in yields because demand for US treasuries on the secondary market is falling. However, when Ben Bernanke announced tapering back in 2013, as soon as the Fed actually started to taper, the opposite happened. In midst of 2014 the Fed cut back on their purchases (and later stopped) and US 10y yields started to fall. The following chart shows the YoY-change of the Fed’s balance sheet vs. the 10y treasury yield:
Yields started to rise again when Janet Yellen started to raise rates in late 2015. If one looks at the yearly change in US 10y yields vs. the Fed’s balance sheet, the picture gets more obvious (Note: The Fed funds rate does not fit into the metric of the left- or right-handed side):
This suggests that the market is expecting a similar scenario to the last tapering, namely that the Fed will start to taper, inflation will peak and then quickly will fall back below the Fed’s 2 % target.
This view is shared by Jeff Snider, Head of Research at Alhambra Investments, and economist David Rosenberg, who expect that inflation indeed will be transitory.
David rejects the objection that the Biden administration will implement an MMT-environment: In a recent Hedgeye talk with Hedgeye CEO Keith McCullough, he answered that all the MMT-talking is just talking without any substance. According to his view, MMT will not become reality.
His point of view is that the situation is comparable to the early 2010s and, as back then, the deflationary economic environment will continue because of weak economic growth, the deflationary effect of rising debt and because of an aging population.
Further he (and Jeff as well) holds the opinion that the recent pick up in commodity prices is already starting to normalize and expects this trend to continue as soon as the supply side is coming back. Both point out that the current data is accompanied by lot of noise and therefore they say that one should be cautious to interpret the recent pick up in inflationary measures as a shift to an inflationary environment. Although both expect that inflation is here to stay for the rest of the year, the expect that it will fade out afterwards.
David rejects the conclusion, that rents will pick up strong because housing prices have already risen. Contrariwise, he argued that one should be careful what one wishes for, because last time when housing caused a pick-up in inflation, it resulted in a deflationary crash.
Finally, he pointed out that all of his clients are asking him because of inflation fears and therefore he considers it an overcrowded trade (although the numbers suggest otherwise, as Keith correctly pointed out). David even rejects that wages will drive up inflation as, according to his view, the situation will change when all the extra benefits end.
Jeff Snider (also in an interview with Hedgeye) points out two more points that I have discussed for several times here: Firstly, the Fed cannot create inflation with QE, because the Fed does print bank reserves, not dollars.
Secondly, the Fed can hardly influence the quantity of money in the real economy because in the current monetary system it is up to the commercial banks expand broad money through credit expansion. It is the commercial banks who simply do not lend enough. For the commercial banks, the Fed’s QE is only an asset swap, where the bond on the commercial bank’s balance sheet is exchanged for bank reserves.
According to Jeff, banks do not lend because the risk spread is so low that it is not worth the risk. Although he is surprised how hot inflation has been running recently, he merely considers it as price-deviations because of supply and demand imbalances, not real inflation.
Thus, Jeff points out that the market is skeptical about inflation because there is so much noise in the data. When he was asked about China, he said that he is not convinced that China has stopped buying foreign exchange reserves (the position on the PBoC's balance sheet has remained flat for almost two years now) and thinks that this looks engineered. According to him, the world is short of dollars and therefore, he points out, it is deflation that is coming, not inflation.
Although I think that both, David and Jeff, are making some very good arguments, but I do not think that we will return to the deflationary environment of pre-2020 because of a variety of differences to post 2008.
For example, I disagree that MMT is just talking and that a republican senate will stop more stimulus and infrastructure bills from happening. MMT will become reality and maybe it already has. Broad money supply has expanded a lot more than it did back in 2008, mainly because of all the stimulus.
Further I take Biden very seriously when he talks about the administration’s goal to push wages higher and especially that Biden will do even more fiscally if the results are not as expected. However, this will not lead to more sustainable growth but only to more malinvestment and more government debt.
The Fed will not have another choice at some point than to monetize the debt and to inflate it away. Although it may fight the rise in interest rates (via YCC?), but this will put further pressure on inflation. Until the next deflationary crash is happening, inflation will not return to pre-crisis levels, at least in my opinion. But until then, the hoarding of (relatively) limited assets will continue…
Have a great weekend!
Fabian Wintersberger
Disclaimer: This is a personal blog. Any views or opinions represented in this blog are personal and belong solely to the blog owner and do not represent those of people, institutions or organizations that the owner may or may not be associated with in professional or personal capacity.
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