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  • Still no deflation: Disinflation then lots of inflation

    Still no deflation: Disinflation then lots of inflation

    As we explained years ago, the Fed has a bottomless bag of tricks to use to fight deflation. When deflation inevitably threatens, the Fed planned to continuously change the rules of the game to fight it, and so they have.

    You did not need genius of foresight to make this call. All you needed was a browser and Adobe Acrobat on your PC, and a strong stomach to read the Fed's deflation play book (pdf) published by the Fed in 2003.

    It was not the only such publication that the Fed issued to try to jawbone inflation expectations up back then, before explicitly carrying out the policy ideas the play book lays out. All of the several dozen papers issued either by the Fed or by the man who now heads it, Ben Bernanke – some as many as 25 years previous – have a common theme: do not, under any circumstances, allow your economy to fall into a liquidity trap. Avoid the zero bound of inflation and interest rates as if the nation's economic life depends on it – because it does.

    Printing money is front and center in all of the anti-deflation policy recommendations in these policy papers issued in accordance with economic policy group-think that is soon to be relegated to the ash heap of history; the economic orthodoxy of any era is a reflection of the political interests of those in charge.

    And here we are, facing down deflation and printing money like there's no tomorrow, because if the Fed does not – or so the Fed believes – there won't be.

    Print, Ben, print!

    Banks borrowed $368 billion per day last week, up from $188 billion per day the week before.


    One question we get frequently is: Where the heck is all of this money going?

    As we forecast February this year, the Fed stopped targeting the price of money but instead the quantity of money in Q2 2008. Since then the money supply has increased more than at any time since the anti-deflation era of 2001.


    The chart above understates the total growth in money aggregates because most of the growth is in commercial banks, although not institutional money market accounts. Growth in money aggregates there is no longer reported by the Fed as they were in M3 which the Fed discontinued in 2006.

    Evidence is that at least some of this money is expanding the credit of commercial banks but you can see from the expansion of bank credit that some of those hundreds of billions are working their way into the banks.



    Less successful is the effort to expand institutional money market accounts.



    If you are curious to know what actual deflation, as opposed to disinflation, looks like, it looks like this. Note the declines in M2 plus CDs and broad liquidity in Japan in the first two years of Japan's debt deflation, from 1990 to 1993.



    Keep that up for a few years and deflation results. After several years of declines in broad money, deflation appeared in 1993.




    In contrast we offer further evidence that the Fed is succeeding in its targeting of money aggregates. We call this chart from the Fed's recent data release on the monetary base: "Showing the Bank of Japan how it's done."


    (Hat tip to iTulip's Lukester)


    Further reading of the Fed literature tells us that the current period of disinflation, should it continue to develop into actual deflation, will be attacked by the "foolproof means" as Bernanke wrote back in the early 2000s: currency depreciation:
    Even if the nominal interest rate is zero, a depreciation of the currency provides a powerful way to stimulate the economy out of the liquidity trap (for instance, Bernanke (2000); McCallum (2000); Meltzer (2001); Orphanides and Wieland (2000)). A currency depreciation will stimulate an economy directly by giving a boost to export and import-competing sectors. More importantly, as noted in Svensson (2001), a currency depreciation and a peg of the currency rate at a depreciated rate serves as a conspicuous commitment to a higher price level in the future, in line with the optimal way to escape from a liquidity trap discussed above. An exchange-rate peg can induce private-sector expectations of a higher future price level and create the desirable long-term inflation expectations that are a crucial element of the optimal way to escape from the liquidity trap.

    In order to understand how manipulation of the exchange rate can affect expectations of the future price level, it is useful to first review the exchange-rate consequences of the optimal policy to escape from a liquidity trap outlined above. That policy involves a commitment to a higher future price level and consequently current expectations of a higher future price level. A higher future price level would imply a correspondingly higher future exchange rate (when the exchange rate is measured as units of domestic currency per unit foreign currency, so a rise in the exchange rate is a depreciation, a fall in the value, of the domestic currency).5 Thus, current expectations of a higher future price level imply current expectations of a higher future exchange rate. But those expectations of a higher future exchange rate would imply a higher current exchange rate, a current depreciation of the currency. The reason is that, at a zero domestic interest rate, the exchange rate must be expected to fall (that is, the domestic currency must be expected to appreciate) over time approximately at the rate of the foreign interest rate.

    Journal of Economic Perspectives
    Escaping from a Liquidity Trap and Deflation: The Foolproof Way and Others
    Lars E.O. Svensson
    First draft: January 2003
    This version: December 2003
    This explains the pig pile into gold by the well-heeled (see Wealthy investors drain supplies of gold by hoarding bullion bars). If not only the US but economies worldwide face deflationary forces, and currency depreciation is the final "foolproof way out" as espoused by the current economics orthodoxy, then competitive currency depreciation is the logical end game as governments pull out the stops to prevent deflation.

    I remind readers that our comments and forecasts on central bank policy should not be construed as approval. We cannot help our readers prepare for the future if we try to impose our own theories on how the economy, financial system, and monetary systems should work. We are interested in what the Fed and other central banks are thinking, not how they should be thinking. We'll have time for that later. So far careful observation of that has yielded, unfortunately, accurate forecasts.

    I leave you with the following history of inflations and deflations since 1800. Note that since every central bank abandoned the gold standard globally there have been two slight periods of deflation. These occurred before 1930. Since the international gold standard was abrogated by the US in 1971, ushering in the second era of floating exchange rates in 100 years – the last one ended badly as well – no deflation has occurred. Japan's experience with "deflation" would not show up on this graph because in no year since 1990 has deflation in Japan exceeded 2%.

    We continue to expect that the actions of central banks to halt deflation will, as usual, in the long run work too well.


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    Last edited by FRED; 10-06-08, 03:38 PM.

  • #2
    Re: Still no deflation: Disinflation then lots of inflation

    From Paul Krugman;
    The obvious answer to sustained deflationary pressures, then, is the now-notorious proposal for "managed inflation": since deflation is the result of an economy "trying" to get the expected inflation it needs, to avoid deflation one must provide that expected inflation by credibly promising that future price levels will be sufficiently high compared with the present.
    And this is where I get nervous. This nervousness is not because the idea of fighting deflation by promising inflation is crazy: it is in fact a straightforward conclusion from quite standard models. Indeed, once one admits that deflationary pressures come from the persistence of a savings-investment gap even at a zero interest rate, it is hard to see how this conclusion can be avoided. But the idea sounds crazy, and that is a problem. How can we get finance ministers and central bankers, who have spent their whole careers preaching the evils of inflation and the virtues of price stability, to accept the idea that price stability may not be an available option?
    If Krugman and Bernanke are thinking on the same lines, it sounds pretty plausible, or maybe scary!

    I've been riding the inflation/deflation roller coaster and switching my opinion on hourly basis. Your input EJ is very much appreciated.

    Comment


    • #3
      Re: Still no deflation: Disinflation then lots of inflation

      To clarify: Are we, then, entering the moment of KA?

      If so, it seems to put us right on the schedule outlined in the Original Ka-Poom theory.

      And C1ue, also, just took a stab at describing possible POOMs here. Yes?

      Am I connecting the dots?

      Comment


      • #4
        Re: Still no deflation: Disinflation then lots of inflation

        Disinflation Anecdote (Snail's Eye View) :

        My wife and I did our weekly shopping yesterday at a local, comfortable middle class supermarket we frequent. Practically everything was on sale. Not a few cents off but a significant, practically across the board discount. Our ticket showed a 14% savings on a $145 buy.

        By the amount of bags filled (sorry for the loose analysis here) this didn't appear to be a large price increase/temporary sale gambit, a commonplace here and I assume everywhere in grocery retail.

        Motive? Critical cash flow for the chain? They have around 12 stores in the surrounding burgs. Time will tell.

        Comment


        • #5
          Re: Still no deflation: Disinflation then lots of inflation

          Originally posted by don View Post
          Disinflation Anecdote (Snail's Eye View) :

          My wife and I did our weekly shopping yesterday at a local, comfortable middle class supermarket we frequent. Practically everything was on sale. Not a few cents off but a significant, practically across the board discount. Our ticket showed a 14% savings on a $145 buy.

          By the amount of bags filled (sorry for the loose analysis here) this didn't appear to be a large price increase/temporary sale gambit, a commonplace here and I assume everywhere in grocery retail.

          Motive? Critical cash flow for the chain? They have around 12 stores in the surrounding burgs. Time will tell.
          Cutting prices to burn off inventory is certainly deflationary. Across the entire retail sector you will see it happen as the recession deepens. The question is, what is the new equilibrium price that your grocer pays for goods and can charge for it? Clearly he cannot stay in business for long if the input costs for his goods stay higher than what he can charge his customers. Input costs must fall as well to match the new discounted sale prices that are meeting demand or he will not be able to restock the next cycle of inventory and sell it at a profit.


          Uh, oh. Not looking so good. Hope he's got a lot of cash on hand to float expenses. Better not be counting on the credit line.

          What happens if half of the grocers in your area wind up going out of business? Then the ones that survive get to charge what they need to in order to stay in business. That may be more than they charge today. As a result your grocer's customers' buying behavior will change. They will buy less and they will substitute lower quality products.

          That's how it is in countries where the standard of living has declined because the nation had lost purchasing power.
          Ed.

          Comment


          • #6
            Re: Still no deflation: Connecting the dots

            Lukester put up this lenghty piece The Fed is Dead. Long Live The US Treasury. today.

            The key take-away for me was that it argues the Fed had only started to "print money" on Sep 17., when it implemented the "Supplementary Financing Program", where the Treasury issues into the Fed, and all the TAFs and whatnot had not increased the monetary base so far.

            This is the most intruiging chart on the Monetary base from the article. http://research.stlouisfed.org/publications/usfd/page3.pdf

            If you look up your gold charts from Sep 17., you will find that was the day when Gold futures went from a low of 777 to the high of 869, the largest one-day increas ever if i recall correctly.

            Comment


            • #7
              Re: Still no deflation: Disinflation then lots of inflation

              China has been tackling inflation by shutting down inefficient steel mills and retrenching other unproductive yet resource-intensive activities and focusing on using methods and technology with higher yields.

              Comment


              • #8
                Re: Still no deflation: Disinflation then lots of inflation

                Originally posted by FRED View Post
                Clearly he cannot stay in business for long if the input costs for his goods stay higher than what he can charge his customers. Input costs must fall as well to match the new discounted sale prices that are meeting demand or he will not be able to restock the next cycle of inventory and sell it at a profit.
                Why would input costs stay high?
                If the grocer is having to tighten his belt by lower prices, why wouldn't those selling what he's re-selling have to do the same? Wouldn't demand destruction affect everyone down the line?
                raja
                Boycott Big Banks Vote Out Incumbents

                Comment


                • #9
                  Re: Still no deflation: Disinflation then lots of inflation

                  Originally posted by FRED View Post
                  Cutting prices to burn off inventory is certainly deflationary. Across the entire retail sector you will see it happen as the recession deepens. The question is, what is the new equilibrium price that your grocer pays for goods and can charge for it? Clearly he cannot stay in business for long if the input costs for his goods stay higher than what he can charge his customers. Input costs must fall as well to match the new discounted sale prices that are meeting demand or he will not be able to restock the next cycle of inventory and sell it at a profit.


                  Uh, oh. Not looking so good. Hope he's got a lot of cash on hand to float expenses. Better not be counting on the credit line.

                  What happens if half of the grocers in your area wind up going out of business? Then the ones that survive get to charge what they need to in order to stay in business. That may be more than they charge today. As a result your grocer's customers' buying behavior will change. They will buy less and they will substitute lower quality products.

                  That's how it is in countries where the standard of living has declined because the nation had lost purchasing power.
                  I'll tell my wife! Good stuff, Fred.

                  Comment


                  • #10
                    Re: Still no deflation: Disinflation then lots of inflation

                    Originally posted by FRED View Post
                    Cutting prices to burn off inventory is certainly deflationary. Across the entire retail sector you will see it happen as the recession deepens. The question is, what is the new equilibrium price that your grocer pays for goods and can charge for it? Clearly he cannot stay in business for long if the input costs for his goods stay higher than what he can charge his customers. Input costs must fall as well to match the new discounted sale prices that are meeting demand or he will not be able to restock the next cycle of inventory and sell it at a profit.


                    Uh, oh. Not looking so good. Hope he's got a lot of cash on hand to float expenses. Better not be counting on the credit line.

                    What happens if half of the grocers in your area wind up going out of business? Then the ones that survive get to charge what they need to in order to stay in business. That may be more than they charge today. As a result your grocer's customers' buying behavior will change. They will buy less and they will substitute lower quality products.

                    That's how it is in countries where the standard of living has declined because the nation had lost purchasing power.
                    ....better make friends with someone in the LDS church now while you can still get some food :eek:

                    Comment


                    • #11
                      Re: Still no deflation: Disinflation then lots of inflation

                      Sadly, this bout of "disinflation" has whacked my precious metal mining stocks in a manner I'm sure Tony Soprano would be proud of. Ugh.:mad:

                      Comment


                      • #12
                        Re: Still no deflation: Disinflation then lots of inflation

                        Originally posted by Chief Tomahawk View Post
                        Sadly, this bout of "disinflation" has whacked my precious metal mining stocks in a manner I'm sure Tony Soprano would be proud of. Ugh.:mad:
                        We have been 100% consistently against PM stocks forever. Why?

                        1. No one ever guesses which companies do not have stupid management.
                        2. Dollar weakness from falling dollar demand will drive up input costs faster than declining dollar value will drive up finished goods prices.
                        3. Now as PM demand falls, finished goods demand will fall faster than input costs; producers will cut production faster than recession will cut demand.

                        The paper gold market will obscure this, although rising spreads between spot and physical are indicative.

                        Hat tip to metalman: watch this site for gold prices. The secondary market will be more reliable indicator of demand for a while.
                        Ed.

                        Comment


                        • #13
                          Re: Still no deflation: Disinflation then lots of inflation

                          Originally posted by raja View Post
                          Why would input costs stay high?
                          If the grocer is having to tighten his belt by lower prices, why wouldn't those selling what he's re-selling have to do the same? Wouldn't demand destruction affect everyone down the line?
                          Supply destruction, raja. Supply destruction...:eek:

                          Input costs are influencing everyone, everywhere. It's more acute in the US$ zone, but it's hitting China and others too.

                          Comment


                          • #14
                            Re: Still no deflation: Disinflation then lots of inflation

                            Originally posted by GRG55 View Post
                            Supply destruction, raja. Supply destruction...:eek:

                            Input costs are influencing everyone, everywhere. It's more acute in the US$ zone, but it's hitting China and others too.
                            you and fred talk about this, no one else i've come across.

                            what's with the blind spot on the supply side of the price level equation? i don't get it. have the deflationists all received a supplobotomy?

                            Comment


                            • #15
                              Re: Still no deflation: Disinflation then lots of inflation

                              Will somebody tell me what I'm missing here? :confused:

                              Originally posted by EJ View Post

                              I leave you with the following history of inflations and deflations since 1900. Note that since every central bank abandoned the gold standard globally there have been two slight periods of deflation. These occurred before 1930. Since the international gold standard was abrogated by the US in 1971, ushering in the second era of floating exchange rates in 100 years the last one ended badly as well no deflation has occurred. Japan's on and off "deflation" does not even show up because in no year has deflation in Japan exceeded 2%.

                              We continue to expect that the actions of central banks to halt deflation will, as usual, in the long run work too well.

                              Originally posted by FRED
                              BLS data confirm deflation in Aug. 2008.


                              A month of negative inflation at annual rates occurred in Aug.

                              There have been 15 months of deflation since 2000.

                              2000 01 3.613
                              2000 02 5.076
                              2000 03 7.292
                              2000 04 -0.700
                              2000 05 2.127
                              2000 06 7.239
                              2000 07 3.541
                              2000 08 0.000
                              2000 09 6.436
                              2000 10 2.094
                              2000 11 2.090
                              2000 12 2.791
                              2001 01 7.094
                              2001 02 2.768
                              2001 03 0.684
                              2001 04 2.064
                              2001 05 6.297
                              2001 06 2.741
                              2001 07 -2.007
                              2001 08 0.000
                              2001 09 4.839
                              2001 10 -3.317
                              2001 11 -0.674
                              2001 12 -0.674
                              2002 01 2.048
                              2002 02 2.045
                              2002 03 3.423
                              2002 04 5.513
                              2002 05 1.347
                              2002 06 0.671
                              2002 07 2.706
                              2002 08 3.385
                              2002 09 2.013
                              2002 10 2.687
                              2002 11 2.005
                              2002 12 2.002
                              2003 01 5.410
                              2003 02 6.773
                              2003 03 1.979
                              2003 04 -4.473
                              2003 05 -1.947
                              2003 06 1.320
                              2003 07 4.004
                              2003 08 5.353
                              2003 09 3.973
                              2003 10 -1.289
                              2003 11 0.651
                              2003 12 3.292
                              2004 01 4.623
                              2004 02 3.270
                              2004 03 2.601
                              2004 04 1.941
                              2004 05 5.245
                              2004 06 4.556
                              2004 07 1.278
                              2004 08 1.920
                              2004 09 2.564
                              2004 10 6.509
                              2004 11 5.149
                              2004 12 0.628
                              2005 01 0.000
                              2005 02 3.821
                              2005 03 3.809
                              2005 04 5.745
                              2005 05 -1.842
                              2005 06 0.622
                              2005 07 8.362
                              2005 08 8.304
                              2005 09 17.114
                              2005 10 2.441
                              2005 11 -5.289
                              2005 12 -0.603
                              2006 01 7.512
                              2006 02 -0.600
                              2006 03 1.821
                              2006 04 6.180
                              2006 05 4.269
                              2006 06 3.636
                              2006 07 6.108
                              2006 08 5.455
                              2006 09 -5.172
                              2006 10 -5.757
                              2006 11 1.195
                              2006 12 7.363
                              2007 01 1.486
                              2007 02 3.656
                              2007 03 5.667
                              2007 04 3.870
                              2007 05 5.684
                              2007 06 3.240
                              2007 07 2.696
                              2007 08 0.231
                              2007 09 4.479
                              2007 10 3.212
                              2007 11 11.278
                              2007 12 4.351
                              2008 01 4.867
                              2008 02 0.283
                              2008 03 4.200
                              2008 04 2.504
                              2008 05 8.089
                              2008 06 13.423
                              2008 07 10.280

                              2008 08 -1.630

                              Before 2000 you have to go all the way back to 1986 to find a month of deflation. In fact, three in a row.

                              1986 02 -2.162
                              1986 03 -6.369

                              1986 04 -4.312

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