Deflation? Are we far from it?

Wow! We see the word „Deflation” everywhere; we see it in every financial publication and hear it every time we turn on financial TV. We see that the pundits who were bearish because of runaway inflation have just recently included deflation as well as inflation to be the problem. We were talking and warning about the ramifications of deflation as far back as the late 1990s. That was when we authored the „Cycle of Deflation” . Whenever we used the word deflation back then, and through 2001, Microsoft Word did not recognize the word and then spell check would constantly try to get us to replace this unusual word with inflation or some other word that started with „de…. .”

You may wonder why I would bring up the fact that we were so early in deflationary warnings which are really only just now becoming recognized as a threat. At that time, I believed that the deflation about which we were warning during the biggest financial mania of all times would have taken place when the bear market started in 2000 and the recession hit in 2001. However, the Fed decided to make sure deflation did not take place by lowering fed funds from 6 ¼ % to 1% and, then kept it there for a year. Remember, 2002 was when Bernanke gave the helicopter speech where he implied that he would do whatever it took to control deflation-„even drop money out of helicopters.” Well, what they did was exacerbate a housing bubble that was already in force and started a second financial mania with stocks following the housing market into the stratosphere.

I wish Greenspan and Bernanke would have let the tremendous overleveraging (even at that time) unwind with the recession and, even though it would have been very painful, let the public repair their balance sheets as they either paid off or defaulted on their debt. At that time, the total debt (public and private) was a very high 280% of GDP vs. 260% of GDP at the worst of the Great Depression. Clearly, the unwinding of the debt back then would have been very painful had the Fed not intervened, but now the debt problem is much larger. Now that the debt has just about doubled they have to deal with a much bigger problem and the pain in deleveraging will be much worse.

The total ratio of debt to GDP reached 373 % of GDP at the peak in 2008 before just recently declining to 360%. As it is stated in the latest special report, „Debt is Still the Major Problem and Deflation is the Painful Solution-Velocity is the Key,” the private debt of approximately $40 trillion is expected to decline towards the $20 trillion level, and the public debt to increase from about $15 trillion towards $30 trillion. The deleveraging of the total debt of 360% of GDP will be almost impossible to control through the Fed’s typical tools. As stated earlier, the Fed was successful in preventing deflation back in 2003 and the recent monetary and fiscal policies were probably responsible for stopping a complete melt-down in the latest financial crisis. However, now we believe the Fed and Administration have run out of ammunition.

All the bulls point to three ways the Fed can bail us out of any economic problem: 1. Cut interest rates paid on excess reserves. That will give incentives to banks to loan out the money rather than get no yield on excess reserves (it is only ¼ of 1% now). 2. Buy more assets (they just finished buying $300 billion Treasuries and $1.25 trillion of mortgage backed securities). This would be the equivalent of Quantitative Easing 2 and it would work just as poorly as QE 1. 3. Moral Suasion -which would have the Fed change inflation targets or state that they will keep interest rates at virtually zero for a very long time? How could that help?

Bernanke had to respond as to what he would do if the economy slowed by stating that he would do either one of the first two options. I don’t think that he has any options that will control the severe problem of deflation that the Fed let get out of control in the early 2000s when they could have let the market forces work to repair balance sheets-just like we show in the first chart with „Cycle of Deflation.”

In the latest „special report” I mentioned above, we show exactly why any new monetary or fiscal stimulus will not be able to reverse the deleveraging of the private sector. The bottom line is the consumer drives the velocity of the Fed’s attempt to create money, and if the consumer turns cautious, the economy cannot continue to recover. The debt is weighing down the average consumer. The non credit-worthy sector of the public has no chance of being able to borrow and spend as they’ve done in the past since banks will not loan them money. The credit-worthy borrowers will not continue borrowing and spending after two 50% declines in the stock market over the past decade. This past weekend, The New York Times published a front page story about the wealthy sector, which had been the major reason for the economic recovery, now cutting back. If we lose this sector, that has been the only driver of the economy, we lose the recovery. Regardless of today’s stock market rally, we don’t expect the economy or stock market to perform well until the consumers rebuild their balance sheets– and that will take a few years.