A Crash Course in Deflation. Seriously…

Seems there’s a lot of data that seems to be pointing to one outcome.  The outcome which shall not be named.  First, there was a piece by Ambrose Evans-Pritchard discussing the decline in M3:

Paul Ashworth at Capital Economics said the decline in M3 is worrying and points to a growing risk of deflation. “Core inflation is already the lowest since 1966, so we don’t have much margin for error here. Deflation becomes a threat if it goes on long enough to become entrenched,” he said.

via US money supply plunges at 1930s pace as Obama eyes fresh stimulus – Telegraph.

*Gasp!!*  Ashworth said it: deflation.  But M3 isn’t kept track of by the Fed anymore.  What is kept track of by the Fed, though, is MZM – money of zero maturity.  And, um, it’s well, deflating:

This was a monthly chart.  But when you take a look at it on a quarterly basis, which is how you need to align the MZM data with GDP data to perform a calculation of velocity, the change looks even more compelling:

Which, given the downward revision in GDP…

Is not that encouraging…

So I recalculated the velocity of money based on the revised GDP data.  The supposed rebound in velocity is looking more and more distant.  This is really a flat-lining.  An absence of decline.

We’re not cheering rebounds or snapbacks.  We’re just happy to not be falling.  If you want to see the data I used, it’s here:

Then Zero Hedge comes out with this whopper:

SocGen’s Albert Edwards chimes in with an observation from a slightly different angle, namely that the collapse of global FX reserves, whose explosion until 2007 “fuelled both global GDP growth and the credit bubble,” which are simply indicative of global imbalances and are a very useful measure of total liquidity, are now plunging. This merely reinforces the deflationary pressures of the plunge in money supply, and forces the Fed into a corner from which there is no escape except by activating another multi-trillion QE program.

via Is The Collapse In FX Reserves Even More Dangerous Than The Plunge In Money Supply? | zero hedge.

There’s also this chart in the post, which I find to be quite interesting:

The thing to note is the amplitude/size of movements in the time series.  Earlier parts of the series have less jumpiness but now we’re clearly in a period with more volatility.  I’ve commented on rising volatility in an earlier post, that fittingly enough, featured some more of Albert Edwards’ charts:

What will the Fed do the next time an easing is needed? Whatever it is, the response will have to be stronger and possibly more unorthodox – more unconventional – than it was before. People in Austin, TX like to say “Keep Austin Weird” and that’s fine. They can keep their weirdness. I sure as hell don’t like seeing my central bank engage in it, however…

But what I wonder is this: are we in for more volatility in economic indicators as Fed monetary policy response looks more and more like a” Twilight Zone” episode and less like central banking?  And with what effect?  What if all this stimulus, all this unorthodoxy in central banking does is – as a best case scenario – get us back to our last cyclical peaks in 2007?  We would’ve replicated Japan.  Richard Koo would be trying to convince us that was a good thing while I look at him like he is a three-headed cyclops.  The image of a three-headed person just wouldn’t capture my level of bizarreness well enough.

via How We Can Be V-Shaped, Yet Japanese At The Same Time « Deep Thoughts by Professor Pinch.

And with interest rates near zero, well, I had this observation:

The credit market is not just priced to perfection: it’s priced to the hilt. At these funding costs, credit creation could be almost unlimited. Yet what are we seeing? The charts I presented above. Illiquidity. Possible bank runs. Carry-traders getting the gas-chamber treatment as Euro-Yen trades blow up. Then there’s the stimulus to stave off bank failures, which gets recycled through abnormally high levels of risk-taking (i.e. moral hazard). The bailout machinery will be running 24/7. Kind of like the Shit Sandwich Deli was 3 years ago.

via Like The Movie “Syriana,” It’s All Connected « Deep Thoughts by Professor Pinch.

In short, this can only lead to one thing, and it ain’t pretty.  Zero Hedge put it pretty succinctly:

The bottom line is that in attempting to fix one problem in a suddenly broken system, another one develops, as everything is interrelated and interconnected in the global economic system, linked up through channels of liquidity, or lack thereof. M3, global imbalances, declining wages, all these are indications that the Fed is certain to lose the war. But not the the next battle, which will be fierce: expect a massive, unprecedented, and record reflation attempt yet by the Fed and the global central banks, that will make all stimulus to date pale in contrast.

Which means that the quantity of money can only go up if the central banks are going to try and foist “stability” on us.  I think there’s plenty of folks that would agree with us.  Where I diverge from Tyler is the ultimate result: a run on gold versus bigger drawdowns on currency.  The dollar funding pressures we’ve seen recently tell me there’s still widespread (and possibly growing) fear that there’s still a lack of liquidity out there.  Frankly, I don’t think the central banks can shovel it out there fast enough in enough channels.

The question is why.  Simply put, repos, reverse repos, currency swaps, etc. are just credit instruments.  Credit is deflationary.  You have to pay back more than you borrow.  That only makes sense if you can make more than what you’ll owe.  But if you can’t, it leads to a restructuring or austerity.  Take your pick.  Real Bureau of Engraving and Printing madness is all that’s left, where M1 would essentially swallow up MZM and M3 levels of money creation.  But the minute that occurs, the run on hard commodities will be on in full force.  Everyone will know the whole gig is up.

Which is why the central banks won’t do it.



Filed under finance, government, macro, Markets, Monetary, risk management, Way Forward, You're kidding

7 responses to “A Crash Course in Deflation. Seriously…

  1. Pingback: A Crash Course in Deflation. Seriously… | rssblogstory.com

  2. Prominent Guest

    Where’s the money?
    See bank’s excess reserves balances at the Fed.
    Will the Fed stop paying interest on excess reserves?
    It probably should as it would add liquidity, even though credit concerns would limit the impact.

    • Those have largely stopped, looking at this chart. Which would tell me banks have already “banked” pretty much most of the excess reserves they had.

      But the issue of paying interest on excess reserves is something that should be explored and thought about some more, though.

  3. Pedro da Costa


    FED FOCUS-New phase of crisis revives US deflation concerns

    By Pedro Nicolaci da Costa

    WASHINGTON May 19 (Reuters) – Ben Bernanke is again being confronted with hints that his sworn enemy, deflation, might be making a comeback. This time though, the Fed chairman’s policy arsenal looks sorely depleted.

    Nearly eight years after declaring war on deflation in a speech that earned him the nickname “Helicopter Ben,” the head of the U.S. Federal Reserve is again confronting the threat of a corrosive cycle of falling prices.

    One of the U.S. central bank’s favored inflation measures, the core consumer price index, rose just 0.9 percent in the year to April, the smallest gain since 1966. Most Fed officials would like to see that number closer to 2 percent.

    “The recent trend in inflation has been swiftly to the downside,” said Eric Green, chief U.S. rates strategist at TD Securities in New York. “All measures of inflation are decelerating.”

    In 2002, Bernanke made a vehement case that central banks were not powerless to stimulate the economy even when official interest rates were pushed near zero. The financial crisis forced him to put those ideas into action.

    But the unorthodox measures the Fed has taken have come at a high cost, including greater political interference with monetary affairs and, ironically, heightened inflation fears due to the sharp increase in the money supply.

    As part of its emergency efforts, the Fed not only slashed interest rates near zero but also bought about $1.7 trillion of mortgage and Treasury bonds, expanding total outstanding credit to the banking system to more than $2.3 trillion.

    Having acted so aggressively, the Fed’s room for further maneuver if needed is constrained.


    Of course, a single month’s decline does not a trend make. Part of the easing inflation trend has been driven by a decrease in housing costs that is expected to bottom out in the next few months as the downtrodden sector stabilizes.

    Yet a sharp recent retreat in commodity prices, which has seen oil prices plunge some $20 in just three weeks to around $68, suggests the disinflation trend is likely to persist.

    Market barometers show the concerns gaining ground among investors. On Thursday, the differential between yields on benchmark U.S. Treasury notes and inflation-protected debt fell to its lowest since October, indicating many see deflation as a real possibility.

    And with Europe mired in a worsening debt crisis that threatens a flashback to the credit-impaired days of late 2008, the possibility of an unwelcome decline in prices begs the question of what Fed officials might do if deflation sets in.

    Deflation, a broad and persistent drop in prices throughout the economy, can eat away at an economy by encouraging consumers to defer purchases and raising the inflation-adjusted burden of debts, fueling further economic weakness in a self-feeding downward spiral.

    “What is going on in Greece, and the Club Med countries in general, must be seen as a significant deflationary shock — underscored by the fact that U.S. dollars are in such huge demand as was the case after the Lehman collapse,” said David Rosenberg, chief economist at Gluskin Sheff.


    In his 2002 speech, entitled “Deflation: Making Sure It Doesn’t Happen Here,” Bernanke outlined what the Fed could do if faced with a deflationary shock.

    But the Fed has already put into play a number of the ideas Bernanke discussed, including buying up government and private debts and committing to holding short-term rates low for a long time to pull down long-term borrowing costs.

    Now, its room for maneuver is limited. The Fed’s relatively modest purchase of $300 billion in longer-term Treasury securities sparked fears the central bank was “monetizing” government deficits by printing money.

    Another possible approach would be to actively raise the Fed’s implied inflation target of about 1.5 percent to 2 percent. This has been advocated by some prominent economists, but does not hold great favor among members of the Fed’s Washington-based board, who fear such a move could unleash an inflation that might be hard to stop.

    John Canally, economist for LPL Financial, said that while inflation expectations, which the Fed sees as a harbinger of inflation itself, are relatively stable, anxiety is showing up in certain places. Just look at the price of gold, he says. The price of the yellow metal, seen as an inflation hedge, has continued to hit new records despite the prospect of renewed economic weakness.

  4. Pingback: Looks Like There’s More To Say. Lots More… « Deep Thoughts by Professor Pinch

  5. Pingback: A Crash Course in Deflation. Seriously - Investing | Colliding With The Future

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