Looks Like There’s More To Say. Lots More…

In one of my recent posts, I got a comment from Pedro Nicolaci da Costa at Reuters.  Turns out the comment was an article Pedro wrote May 19th.  Now, without psychoanalyzing things too much, I could only conclude there are three reasons why an article would be left as a comment on a post.  Especially a post of mine that may have had 5 people read it:

  • Something was done right, let’s extend the conversation.
  • You’re a total tool.  Read this and the STHU memo that’s attached.
  • Too little, too late.  Thanks for playing, but you can go back to sleep.

I’m going to assume it’s the first but I know the second and third (as well as others) reasons can’t be ruled out.  So let’s start out with a quote found in the post:

“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.”

I’d concur, if your objective is to measure inflation based on price levels, which is the normal economic definition:

That was looking at PCE, on a continuously compounded annual rate of change.    The average over the 5yr period in this chart is 2.18 percent.  In April, it was 0.2 percent.

The next one is CPI excluding food & energy, looked at the same way:

The CPI view gives you a more distinct trend, and it’s easier to see prices are falling.  Here the average over the same 5yr period was 1.93 percent.  In April, it was 0.6 percent.

Two measures of prices, both telling the same story.

Here’s the way the Reuters article looked at it:

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.

Now let’s look at a chart I constructed of this:

That’s a well-defined trend lower.  But why?

This probably has something to do with it:

I think a breakdown in the velocity of money explains a good bit.  Fewer transactions pointing to lower demand which drags prices lower in turn.

But let’s continue…

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.

There’s no question it has already set in.  To me, deflation is as much a mind set as it is a data point.  One can make the argument that Greenspan, Bernanke, et. al. were right in seeing some of the signs in ’01 and ’02.  The devastation brought on by the turn from .com to .bomb was as much a psychological trauma as it was a financial one.  But the financial impact was muted.  Why?  That was a destruction primarily of savings & investment.  The amount of leverage involved in .com investing was relatively small when compared to real estate, where most of the money – if not all of it – was borrowed.  There’s an asymmetry when leverage is used in an investment or purchase.  Think about the use of margin in stock investing.  Yes, it can boost returns but too much can put you under in a hurry.  And it doesn’t take big price moves to do it when big amounts of leverage are employed.

Sound familiar?  It should.  Interest rate convexity works very much the same way.  Which is why the uptick in Libor is so disturbing…

This is a good quote from a good economist, David Rosenberg:

“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.

Far from being a perma-bear (and I’ve read him for more than 6 years, so that includes when he was at Merrill), I just think he’s a very cogent macroeconomist.  I have the utmost respect for him.  And he’s right: ECB/EU guarantees don’t mean a thing when they’re denominated in Euros.  Plus, when assets are bought on credit and balance sheets expand via credit, asset price declines are the last thing anyone wants to see.  Because as the assets fall in value, equity evaporates and debt gets destroyed.  And that debt is an asset to someone.  So it just cycles through the system that way, destroying almost everything in its path.

Then there’s this:

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 .

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.

I think many of us would agree the Fed has very little left in the way of magic tricks to pull rabbits out of a hat.  And the purchases of Treasuries is something to think about, but it pales in comparison to the MBS purchases the Fed has undertaken.  Securities with deteriorating credit characteristics and they were the only buyer.  That means what once were highly liquid securities aren’t so liquid anymore, which presents all sorts of problems for the Fed since they stopped buying them and now have to figure out how to offload them.

And it ends with this:

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.

The price of gold is being depicted as an inflation hedge, when really people are buying it now because political risk – in the gold buyer’s mind – is unforgivably too high.  People are worried and in some cases just flat out mad at what governments are doing – forestalling losses and bailing out bad actors/agents (to use the economic parlance) – and they’re not going to take it.  Are they willing to move back to barter?  Because that’s the ultimate revolt against our current fiat-based, electronic payment networked world.  Our system is set up to facilitate electronic, instantaneous movements of little pieces of paper and coins.  Not physical gold nuggets.  We used to do that and I don’t think many people want to go back.

So the point is simple: folks should realize deflation is here, it’s not going anywhere and the Fed has probably spent most of (perhaps all) its bullets trying to fight deflation and doesn’t have much else left.

To the folks at the Fed: good luck with that.


Filed under finance, macro, Markets, Monetary, Way Forward

3 responses to “Looks Like There’s More To Say. Lots More…

  1. Pingback: Looks Like There’s More To Say. Lots More… | rssblogstory.com

  2. C

    Could you please explain in more detail how debt destruction “cycles through the system… destroying almost everything in its path”?

    Is there a way to destroy debt without these negative impacts?

    • Think of it this way: 1) Changes in asset values cause borrowers to reassess debt loads. 2) Reassessment leads to some portion of that debt defaulting. 3) That leads to losses at banks, higher loan provisions. 4) Credit risk is higher, less borrowing is done.

      All the while, this is also cycling through to other parts of the economy that drag the value of everything lower as the use of debt is shunned.

      Truth is, it’s happening now like a slow bleed.

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