The Specter of Global Deflation

[IndependentlyPoor]

Scary article about the possibility of deflation from an surprising source.
AEI - The Rising Threat of Deflation

Some quotes:

• "By later this year, persistent excess capacity will probably create actual deflation in the United States and Europe. Moreover, the recent appreciation of the dollar, especially against the euro, exacerbates the U.S. deflation threat."​
• "During the Great Depression, the Federal Reserve allowed the money stock to fall rapidly because, among other concerns, Fed leaders feared inflation. The disastrous consequences, a serious exacerbation of the economic contraction already underway following the aftermath of a bursting bubble, are fully articulated in Milton Friedman and Anna Schwartz's Monetary History of the United States, 1867-1960 (Princeton University Press, 1963)."
  ​
• "In fact, banks have virtually ceased to function as financial intermediaries since 2008, preferring to use the zero cost of money provided by the Fed to finance purchases of Treasury securities instead of supplying loans to households and small businesses."
  ​

 

[dex]

I agree with it that deflation is more probable before inflation. I don't agree with some of the reasons why it will occur and the Keynesian focus - cause and cures.

We have had a debt bubble that is deflating through defaults, reluctance to borrow, inability to borrow, no need to borrow (no need for increased production).

I think a large default/crisis - sovereign or USA state will be the tipping point. Fear is the prime motivator at this point in the markets.

When the crisis comes there will be debate as to a bale out. If there is no bale out; that will be blamed for the future decline. If there is a bale out; it will be deemed too small and blamed for the future decline. Nothing will be able to overcome the fear in the markets. People are scared of the market declines since 2000. We have been in a secular bear market since 2000 - they can last as long as 18yrs(check number). Bottom in stock market 2013 - 2016 area?

Remember the 'Wealth Effect'; this is the other side of the coin.

I still have some money not in cash. I hope to be 100% in cash in August.

 

[brewer12345]

Meh. Personally I watch capacity utilization figures for the US as they trickle upwards. I also note some interesting stuff in a lot of industries. As an example, I have been an investor in MEOH for years. The company is the world's largest producer of methanol with a mid teens market share. They have always shown upcoming additions to global capacity in their investor presentations, generally several million tons of annual plant capacity in the coming 3 years. I was struck by their most recent presentation. Other than their own new plant coming on line any day now, there are one or two smallish plants coming and then nothing, for the first time I can ever remember that being the case. It takes a good 5 years to build one of these plants, starting from the planning stage. None seem to even be on the drawing board. When current excess capacity becomes fully utilized, it seems pretty likely that we are in for some price spikes and/or shortages for a while until new capacity can be built. I would be greatly surprised if a similar story were not playing out in a lot of other industries around the world.

 

[Gone4Good]

We have had a debt bubble that is deflating through defaults, reluctance to borrow, inability to borrow, no need to borrow (no need for increased production).

How is this different from anything written in the article?

 

[Delawaredave5]

What asset classes help you during deflation ? Any ? Are they the "opposite" asset classes that help you during inflation ?

So cash under the mattress is bad during inflation (as the purchasing power evaporates) and cash is "good" during deflation (if you hold cash longer it buys more)?

What about stocks and RE during deflation ?

Half of the articles I read talk about looming inflation, other half talk about looming deflation. So I do not see a logical basis for any asset allocation changes due to risk of inflation or deflation.

 

[Gone4Good]

What asset classes help you during deflation ? Any ? Are they the "opposite" asset classes that help you during inflation ?

The best asset class for deflation is a long-term, fixed-rate, bond issued by a creditworthy borrower. That's typically seen as sovereign debt (30-yr Treasury bonds), but with sovereign risk on the rise, that is no sure thing this go-round. The next best, then, would be cash under the mattress.

Stocks generally fair poorly because they lose pricing power and margins collapse. That is compounded by increases in the real cost of the leverage on their balance sheets. Real Estate declines with general prices and could suffer as a leveraged asset class. Commodities should decline also, and we've seen that already, except gold, of course.

 

[dex]

What asset classes help you during deflation ? Any ? Are they the "opposite" asset classes that help you during inflation ?

So cash under the mattress is bad during inflation (as the purchasing power evaporates) and cash is "good" during deflation (if you hold cash longer it buys more)?

What about stocks and RE during deflation ?

Half of the articles I read talk about looming inflation, other half talk about looming deflation. So I do not see a logical basis for any asset allocation changes due to risk of inflation or deflation.

You have to think about it in cycle terms.
1. Before market or public acknowledges deflation - buy US Treasury Bonds and/or be in cash
2 When the market acknowledges deflation - stocks & corp bonds down, US treasury bonds up
3 General public acknowledges deflation - stocks & corp bonds down, US treasury bonds up ... more. After this happens (Low?) buy Vang High Yield Corp bonds or FAGIX (they will provide income and appreciation), you can buy AAA Corp bonds if you want also, if you want to buy stocks buy those with paying regular dividend and a high profit margin; they will be recommended as safe havens by investment companies as will food companies - people have to eat.
4. As the economy improves sell the bond funds (or keep it to your allocation) and safe haven stocks and buy stocks that were beaten down
5. if inflation stays low you should be OK with that - if it picks up switch from stocks/bonds to commodities

All this is easier said than done.

Here is the fly in the ointment - what is the cause of the deflation? If it is caused by European sovereign debt or some sort of banking/other company chain reaction of defaults. Then the above would work.

What if it is a USA state - California, Illinois,NY (that I know are in bad shape) - that can not service its debt. What would the economic situation look like? Would the dollar fall drastically causing a steep increase in the cost of imports with stagflation as a result? Would the Fed raise rates to lower inflation and support the dollar which would hurt the economy?

 

[Tigger]

Scary article about the possibility of deflation from an surprising source.

I have NO opinion on whether inflation or deflation is the most probable outcome. Both seem possible.

But for fun, I'll put on my paranoid hat:

1) One of the few ways the US government can deal with its excessive liabilities in an gradual way that doesn't encounter much resistance, is to inflate its way out of them.
“The way a reserve currency nation gets out from under the burden of excessive liabilities is to inflate, devalue, and tax.”
-- Bill Gross
“By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.”
-- John Maynard Keynes

2) But if it wanted to do that, it probably wouldn't be a good idea to admit it.
“If markets were to believe, and I’m not saying it’s likely, that inflation is going to be the route that the U.S. is going to take to resolve this problem, then you could have a crash of the value of the dollar,”
-- Nouriel Roubini.

3) Therefore, it could be useful to spread "deflation propaganda". Some believe this is actually happening.
"In my opinion, this "deflation" propaganda is crucial to further promote the Federal Reserve's agenda of creating even more inflation as a "cure" for the ailing economy."
-- Puru Saxena

But I really have no idea what we're going to get and whether the government or FED have a hidden agenda.

 

[dex]

I have NO opinion on this.

But for fun, I'll put on my paranoid hat:

1) One of the few ways the US government can deal with its excessive liabilities while encountering the least resistance, is to inflate its way out of them.
“The way a reserve currency nation gets out from under the burden of excessive liabilities is to inflate, devalue, and tax.”
-- Bill Gross
“By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.”
-- John Maynard Keynes

2) But if it wanted to do that, it probably wouldn't be a good idea to admit it.
“If markets were to believe, and I’m not saying it’s likely, that inflation is going to be the route that the U.S. is going to take to resolve this problem, then you could have a crash of the value of the dollar,”
-- Nouriel Roubini.

3) Therefore, it could be useful to spread "deflation propaganda". Some believe this is actually happening.
"In my opinion, this "deflation" propaganda is crucial to further promote the Federal Reserve's agenda of creating even more inflation as a "cure" for the ailing economy."
-- Puru Saxena

But I really have no clue if we're going to get deflation or high inflation. Both seem possible.

I agree with the concept and if we currently had higher inflation it would be easy for the government to do it. At this point in time I don't know how they would do it. The Fed and other central banks created a lot of money recently and it hasn't moved the inflation needle. Individuals are fearful, any money they are getting is going to pay down their debts and savings. Banks are borrowing money from the Fed at 1/4%(? check #) and buying 10 yr Treasury bonds paying 3 3/4% - not lending it.

The only way I can see it happening is if a state defaulted on its bonds and the government not only guaranteed payment of the interest but bought the bonds from the bond holders to get money to people. We bought GM so maybe it isn't so far fetched.

 

[Pete]

Except for healthcare and schooling maybe, deflation (decreasing cost of living) is already here.

The article talks about deflation crushing profit margins. Profit season is upon us and we'll see if there are any effects. We could have a profit rally due to decreasing competition (fewer brands out there). I've noticed fundamentals like payout and quick ratios signaling companies are cannabalizing themselves...perhaps to show greater profits. Increased profits for all the wrong reasons....? Maybe.

New home sales down 33% after the stimulus ended....duh. An overwhelming number of baby boomers are now "more worried about the return of their money rather than the return on their money". The rises in the stock markets have been on really thin volume. Time to really be doing your homework.

I still maintain inflation (cost of living increases) will return at a time not of our own choosing from places like China, which is stockpiling money that is appreciating, and is experiencing a near 10% growth rate. They will soon be feeling wealthy and will become the new "consumers of last resort".

California coastal property and school tuitions have maintained or risen I believe due to this phenomenon. Not long ago China tried to buy Union 76. The Chinese bought more cars than Americans last year. They will continue to flex their muscle.

 

[Gone4Good]

3) Therefore, it could be useful to spread "deflation propaganda". Some believe this is actually happening.
"In my opinion, this "deflation" propaganda is crucial to further promote the Federal Reserve's agenda of creating even more inflation as a "cure" for the ailing economy."
-- Puru Saxena

Yeah, except many economists who are worrying about deflation are actually calling for the Federal Reserve to raise inflation expectations, not lower them . . . possibly with an explicit inflation target. Anyone who knows anything about Fed Policy (and inflation drivers) knows that inflation expectations are extremely important. It is counter productive for the Fed to try to raise inflation and tamp down inflation expectations.

Besides, inflation data continues to decelerate. I guess the one way inflation hawks can avoid admitting they've been wrong for two years running is to claim that the data is manipulated. But to do that you'd also have to assume that the bond market, which has been driving down rates and TIPS break-even spreads, is completely stupid.

 

[Tigger]

Anyone who knows anything about Fed Policy (and inflation drivers) knows that inflation expectations are extremely important. It is counter productive for the Fed to try to raise inflation and tamp down inflation expectations.

Yeah but you want people to expect some inflation, not get scared about the risk of very high inflation. So if you're creating dangerous amounts of money you could say "OMG THERE'S A RISK OF DEFLATION!" to keep people from complaining about the FED's efforts to inflate. Extraordinary messes require extraordinary trickery.

I guess the one way inflation hawks can avoid admitting they've been wrong for two years running is to claim that the data is manipulated. But to do that you'd also have to assume that the bond market, which has been driving down rates and TIPS break-even spreads, is completely stupid.

How could you make everybody glad to buy US Treasuries? By creating a lot of hype about how bad things are in Europe? "OMG Greece is bankrupt, now the whole EU is going to die!" (Do not pay attention to California and other states and cities that are close to default)
I don't know if the bond market is stupid, but maybe the above's ONE of the reasons why the USD looked like the least bad choice for a while.

 

[MichaelB]

Excess capacity exists, but so does depreciation and capacity destruction. US internal demand is stable and growing slowly, and demand in emerging countries is growing at a sustained rapid pace.

Banks are lending lots of money, though not as much as before. To say “banks have virtually ceased to function as financial intermediaries since 2008” is wildly inaccurate.

Real chronic deflation is a possibility, but in the US would show itself in housing prices, MBS and other debt instruments.

The slow-growth with deficit state we’re in now can be sustained for a long time. IMHO the real concern we face is long term unemployment.

 

[IndependentlyPoor]

Krugman has link in his blog to a 2002 Bernanke speech on deflation and possible Fed action to combat it. It is interesting to read what Bernanke was thinking way back then. Not surprisingly, the Fed has tried some of the things he proposed. I find it somewhat reassuring that he was thinking about such a scenario and considering strategies well in advance.

Apologies if I have linked to this speech before. I just realized that I have it bookmarked.