Understanding Inflation, Deflation

"I am pleased to report the inflation monster has been captured and placed in a jar".

This stunning announcement was made by the European Central Bank (ECB) along with a pamphlet entitled "Price stability: why is it important for you?" You might consider it to be entertaining but it does not make it as an educational tool or as a source for information. Perhaps the real goal of the pamphlet was really the self promotion of the ECB. Unfortunately, neither the pamphlet nor its accompanying video ever mention that the real cause of inflation is the excessively low interest rates, excessive credit creation and the printing of money by the central banks themselves. What is even worse; is that there is not even an attempt to explain why 2% is such a sought after inflation target in the first place or why they think that across the board prices can be contained by simply setting short term interest rates. Do they not realize that if somehow they managed to achieve their goal, that would still mean a 50% drop in the value of the currency in little over 35 years?

Why should inflation be targeted at 2% and not 1% or 3%? Why not Zero?

Why should any inflation be targeted at all?

Even if it was smart for some reason to target prices, can prices really be measured accurately?

What do central banks do to overcome the lag effects of monetary tightening or easing? Does it simply require blind faith or "can they even recognize a neutral interest rate when they see it"?

The main problem is targeting prices in the first place. Sometimes the creation of new money flows into real estate other times it flows into stocks and bonds and at other times into wages, goods and services. Sometimes productivity improvements mask inflation. At other times falling commodity prices mask inflation. Of course I am talking about "real inflation" as measured by increases in money supply as opposed to hedonically adjusted price inflation as published by the governments and central bankers. In the mid-to-late 1990's, "real inflation" (a rampant increase in money supply), was masked by productivity improvements, falling oil prices, and falling prices of imported goods from Asia.

Greenspan called it a "productivity miracle". Massive increases in money supply fueled the late 1990's stock market bubble and spawned the nonsensical talk about a "new paradigm". Then "after the bubble burst" Greenspan refused to allow the recession to run its course and in a sheer panic brought on by 9/11, he slashed interest rates to 1%, fueling the biggest housing bubble the world has ever seen. So here we are, a mere three short years later now facing a "new paradigm" in Real estate accompanied by debt levels which are the highest in history at both the consumer and governmental levels, with the corporate sector not too far behind.

Greenspan left office in January but not before taking interest rates to 4.5% and leaving it to Bernanke, the new FED chairman to complete the round turn trip back to 6.5 % from whence it all started.

Like the ECB, Bernanke wants to target price inflation at 2 % But in spite of all the hedonic adjustments and with all the nonsense about core inflation vs. non-core inflation, with all the imputed economics, the understating of medical costs, and with the enormous discrepancies between rental costs vs. housing ownership costs, there is just no possibility for anyone to recognize a real 2% INFLATION if it hit them over the head and they knew what Inflation really means.

Compounding the problem for these erstwhile "inflation fighters" is energy costs; and as long as they and our esteemed politicians keep blaming big oil and the inelasticity of Demand as the main reasons for high prices they will never accomplish their goals or be able to find any solutions. Everyone knows that energy costs are rising due to increased world wide demand brought about by Central Bankers flooding the world with money and cheap credit. But naturally they blame China and India but they didn't just start buying in mid 2005. Another reason oil costs are high is due to fear of possible supply disruptions related to geopolitical matters. But apart from easy money the real reason for the sharp increases in prices is congresses inability to pass a rational energy policy as asked for by the president. Since 85% of both continental and off shore USA is closed to exploration. Simply opening up ANWAR would bring the price of oil back down below $45/bbl while opening up the rest of the country would drop prices back to below $25/bbl within three to five years. Can you imagine what that would do to our country's security as well as to our political bargaining power? Finally, oil and natural gas demand are relatively inelastic in the short run only. As prices go up, people more or less have to pay it but they can and will adjust their consumption after a reasonable time lag. In reality there are very very few inelastic products. To maintain a CPI inflation target of 2%, central banks may have to raise interest rates to unreasonably high levels if energy prices are included in their measurements. That clearly would be unacceptable policy. The root cause of the problem of course is targeting prices rather than money supply in the first place.

The Deflation Monster

OOPS I almost forgot, the ECB claims to have "the deflation monster" bottled up as well.

The ECB calls the "deflation monster" a problem when in fact deflation as they define it (falling prices) could in reality be a blessing, given the current natural state of affairs. Rising productivity is "price deflationary": more goods are produced faster by fewer people. So is outsourcing deflationary, prices naturally decline as a result. Look at how many few farmers today produce more grain than 100 times as many farmers did a hundred years ago. Wheat prices recently fell to 1943 levels. Is that a problem? It's only a problem because the US and ECB waste billions every year on farm subsidies.

Does everyone not realize that China is actually losing textile jobs? The enquiring mind might then be asking: to whom? The answer is; to no one: Fewer workers are needed to turn out the same amount of goods using some of the world's most modern and most efficient mills. That is one of the reason all this protectionist talk you hear right now in Congress is total nonsense. Those jobs (that no longer exist) simply are not coming back ever. Cranking up money supply in an attempt to create jobs lost by productivity improvements and outsourcing can only result in asset bubbles and/or in excessively increased overcapacity. Besides, who is it that does not want lower prices on goods and services?

If deflation is such a good thing, why do central banks fear it?

One simple answer is because deflation is debt's worst enemy. If asset prices and wages fall, people can not possibly pay back what they owe. Banks and credit card companies don't seem to like that state of affairs. Is that a problem with deflation? No, that is a problem created by a reckless lending, easy credit, and endless cheerleading by the media, every time consumer spending rises and people sink heavier into debt.

The second answer is because inflation benefits those that receive new FED "money out of thin air" first; the government and the banks. The former via automatic tax increases not indexed to inflation (especially property taxes and the dreaded AMT), the latter simply because banks are first in line to receive money from the FED at rates no one else can get. By the time lending standards drop so that the masses have access to the easy credit, the boom is well underway. By the time credit is granted to anyone and everyone, the boom is just about over. Those buying assets late in the game will eventually be crushed by those selling assets that got in early. Inflation, may seem to be good in the short run, eventually becomes a moral hazard.

The Pivot Point

We are now at or close to the topping out point, which is the point at which consumers can not or will not take on any more debt and/or Mortgage corporations and Banks are unwilling or unable to extend more credit. We now seem to be hitting those topping points simultaneously in many areas: jobs, housing, consumer spending, and credit expansion.

The poor investments of the must have-it-now, generation is about to be unwound. We are where we are because Central Banks have printed ever expanding amounts of money to prevent the normal business cycles from working, to satisfy politicians wanting to get re-elected. Remember "it's the economy stupid". But the only thing the Central Banks have accomplished is to putt off the inevitable deflationary credit crunch while making sure it will be a lot worse in the end. They have definitely NOT eliminated the business cycle.

There are many that think true deflation (decrease in money supply) can not happen under a fiat money system but perhaps the point is moot. Money supply itself actually never contracted in Japan. Instead, it grew very slowly for a long time as bank credit contracted for more than five years consecutive years. Clearly there was a credit contraction so how did money supply still manage to grow? Fiscal deficits were ramped up to dizzying heights, Island Airports and roads to everywhere were built, and the Bank of Japan monetized all of it. I don't think the Government and the FED could get away with that here in the USA, especially since unlike Japan, where they have a 40% savings rate our savings rate is close to zero plus the fact that Japan's Gov. Debt is owned by the Japanese, unlike the USA that owes the rest of the world over $3 Trillion. A financial crisis that brings about massive debt repudiation would cause a massive shrinkage of the money supply (the true definition of deflation) In addition, the velocity of money plummeted in Japan. The net effect of the credit contraction on prices was clearly "deflationary". Prices across a broad range of assets, goods and services fell. Indeed, practically everything fell in price except government bonds.

People were amazed at the alleged "bond bubble" as well as the Zero Interest Rate Policies of the BOJ. However, a 1% interest rate on a 10-year bond makes sense when prices are falling 2.5% annually, the real yield becomes 3.5% (1% interest rate + 2.5% deflation) which is obviously far higher than 1% stated rate. Perhaps a practical way to think of deflation under a FIAT system is the destruction of credit/debt that exceeds the growth of the money supply.

Regardless of social, economic and political differences I expect the USA to attempt to follow in the footsteps of Japan even though the circumstances are vastly different. Although a central bank might be able to sustain a certain amount of inflation by resorting to extreme measures, like "dropping money out of helicopters" it can not stop the inevitable credit contraction. Nor will the FED bail out consumers at their own or other creditors expense. The Fed like the BOJ will stop short of destroying themselves and their power. At some point, most likely due to the Real Estate Bubble implosion, consumers will be unable to take on more debt and/or because banks will refuse to extend consumers additional credit as the value of their assets collateralizing their loans tumble; consumer bankruptcies will soar as the various credit bubbles implode. Furthermore, in a world awash in overcapacity there will be no need for corporations to borrow to make investments when they are awash in over capacity. That is why the Bank of Japan failed to defeat deflation and that is why Bernanke will fail as well.

In due time I suspect we will find out that the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 will fail in its intended purpose. We have already seen massive bankruptcy filings to beat the October deadline. Given that there is now a "means test" based on median family income, perhaps a way around that test is for people to lose their jobs. If so, that will only increase the size and number of the write-offs during the credit counseling and waiting periods.

One of the complaints against Japan in their long battle with deflation was Japan's refusal to write off bad banking sector loans. The USA's "solution" to that problem in the past was to create ultra large interest rate spreads, so that the banks can soak the borrowers, making abnormally high profits as they fight their way back to profitability. However, this time I am convinced that this will backfire on the banks in ways we have not yet even begun to dream (Nightmares) of.

The problem by now should be obvious. Central Banks are attempting to do the impossible. Arguably the best thing that could happen would be for the Central Banks to abolish themselves. Since that is not about to happen, let's instead turn to more practical solutions. Instead of trying to achieve "price stability" which as we noted is something that can neither be achieved nor measured, how about shooting for "money supply stability" instead?

Central banks should refuse to monetize government spending and trade deficits

Central banks should let the market set interest rates

Central banks should begin tightening reserves requirements in order to rein in the banking systems ability to "create money out of thin air"

Life would be so much simpler if Central Banks everywhere would stop trying to micromanage the CPI, the currency, and job growth; mutual exclusive objectives. They are plainly trying to achieve nirvana when nirvana can not possibly be measured, let alone be achieved Nirvana like Shangri-La is only a pipe dream and not of this world. like it or not as long as we have Central Banks or Governments that influence both credit and the money supply we will continue to have economic cycles no matter how much the Central Banks try to avoid or postpone them. All they have ever succeeded in doing was to make matters worse. However if we could somehow curtail the role of central banks then those cycle peaks and valleys would not be as exaggerated as they come to be. It seems as if we have learned nothing from the great depression or from the more recent experience of Japan. I fear things will have to get a lot worse before they can eventually get better.

BULLS MAKE MONEY, BEARS MAKE MONEY, PIGS? THEY GET SLAUGHTERED

I have received a great many emails inquiring about my reasons for choosing March to May 2006 as the outside date for the resumption of the BEAR MARKET, keeping in mind that the next market break will probably be an Elliott Wave Third Wave which will be at least 61% more severe than the 2000 - 2003 Wave One. In my estimation the market should have normally peaked in December but this coming top will not be just a normal correction in an ongoing bull market. It will be a top similar to the 1930 top and therefore, in my opinion this last rally required an additional three months to get to the record high levels of Euphoria (check out the VIX) that usually coincides with a major top that convinces everybody that it's the beginning of a new bull market. By the time this rally was over there was virtually no more money left to invest. Check out mutual fund cash levels. The oil shock should be showing up everywhere, even in the Governments CPI #'s. The Bursting of the real estate bubble which has already begun is already making itself noticed. Most of the 1 to 2% teaser mortgages should be coming due right about now resulting in new all time high levels of defaults. We are now at 5% Interest rates and looking down the barrel of 5 1/4% Plus. That plus the flat yield curve will damage the carry trade, which means hedge fund and Bank profits, will be soon turn into losses bigger than anyone now realizes. Soon even the Wall Street analysts will finally come to the realization that double digit profit growth has never been a given and there is no new profit growth paradigm.. Look what's happening now when a W.S. darling has a great quarter but does not quite live up to expectations (GOoG, YHOO, INTC). Slowly but surely most of the die hard bears have either turning bullish or are quietly sitting on the sidelines. There is more but I'll close with a final warning "we are living on borrowed time" What happens when the realization sets in that the New Paradigm of 15 to 25% annual profit gains like all other new paradigms never really existed?

Do you have the courage to stand alone? We have been living on borrowed time for quite some time now. You can ignore the warning signs at your own peril as we rapidly approach that final window of opportunity to cash out of stocks, bonds and real estate investments. Believe me when I tell you that if you wait to see the signs it will definitely be too late as you will be trampled in the mad rush to the exits.

GOLD AND SILVER

We finally got that pull-back in Gold and Silver that some were praying for. But now that its here most everyone has lost their nerve or has turned bearish. We are now in the last good chance to buy Gold cheap. So what are you all waiting for. How many more times do you want me to begin my articles by I told you so?

Aubie Baltin CFA, CTA, CFP, Phd. (retired)
Palm Beach Gardens, FL
[email protected]
561-840-9767

June 13, 2006

DISCLAIMER
The above is my personal opinion, and in no way be deemed investment advice to buy or sell anything. It is submitted purely for informational purposes, based upon my understanding of the markets.