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The Truth About Deflation: It's Closer Than You Think

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Deflation
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br />"We are on the eve of a deflationary shock which will likely reduce equity valuations from very high to very low levels"...it is increasingly likely that one event will be the catalyst to very rapidly change inflationary into deflationary expectations. Indeed, when key prices are already falling across the globe, one should expect one key major credit event to occur." Russell Napier, "An Ill Wind," CLSA, selected excerpts, zero hedge.

Deflationary pressures are greater today than any time since the end of the recession in March 2009.

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In September 2011 the annual rate of inflation was 3.9 percent. At present, the rate is just 1.0 percent and trending lower. Inflation has continued to fall despite five years of zero interest rates and three rounds of quantitative easing. For all practical purposes, the Fed's large-scale asset purchases (LSAP) have had no impact on inflation at all, in fact, some analysts believe the Fed's polices may be counterproductive. Take a look at this from Stephen Williamson's New Monetarist Economics blog:

"Back in days of yore, my concern was that we could indeed get higher inflation. How? I had thought that the Fed had the ability to control inflation, but when push came to shove, they wouldn't do it. Once people caught on to that idea, we could get on a high-inflation path that was self-sustaining. Of course, since I said that, I've continued to work on these problems, and stuff has been happening. In particular, we're not seeing that high-inflation path. How come?

"With the nominal interest rate effectively at the zero lower bound, the rate of inflation is being determined primarily by the liquidity premium on government debt. Once we recognize that, it's not surprising that the inflation rate has been falling for the last three years...

"In general, if we think that inflation is being driven by the liquidity premium on government debt at the zero lower bound, then if the Fed keeps the interest rate on reserves where it is for an extended period of time, we should expect less inflation rather than more...

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"The Fed is stuck. It is committed to a future path for policy, and going back on that policy would require that people at the top absorb some new ideas, and maybe eat some crow. Not likely to happen." ("Liquidity Premia and the Monetary Policy Trap," Stephen Williamson, New Monetarist Economics blog):

Williamson is not alone in his belief that the Fed is on the wrong track. Economist Warren Mosler arrives at the same conclusion although there are notable differences in their analyses. Here's a short clip from an article by Mosler which wraps it up in one paragraph:

"Theory and evidence tell me it's impossible for the Fed to create inflation, no matter how much it tries. The reason is because all the Fed does is shift dollars from one type of account to another, never changing the net financial assets held by the economy. Changing interest rates only shifts dollars between 'savers' and 'borrowers' and QE only shifts dollars from securities accounts to reserve accounts. And so theory and evidence tells us not to expect much change in the macro economy from these primary Fed tools, making it impossible for the Fed to create inflation." ("It must be impossible for the Fed to create inflation," Warren Mosler, Huffington Post)

The Fed is stuck in an ideological cul-de-sac mainly because its members ascribe to Bernanke's monetary theories which simply don't work. Here's a clip from a speech the Fed chairman gave to the National Economists Club in 2002 that gives us a glimpse into his thinking:

"Under a fiat money system, a government" should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero." Ben S. Bernanke, "Deflation: Making Sure It Doesn't Happen Here," Federal Reserve, November, 2002

Okay, so where's the inflation, Ben? The Fed's 2 percent inflation target continues to move farther away the longer the Fed's programs stay in place. Even more shocking is the fact that "The Fed's preferred measure of U.S. inflation, the personal consumption expenditures deflator (PCE), showed last week that prices rose 0.7 percent in October, the least since 2009." (Bloomberg) So even by the Fed's own standards, QE and zirp have been a bust.

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The reason for this is simple: QE does not raise inflation because QE does not increase incomes, wages or credit. The reserves that are created via QE remain in the banking system where they buoy asset prices by reducing the supply of stocks and bonds available for sale. But there is no transmission mechanism for delivering money to the real economy where it can increase activity, inflation and growth. The fact is, QE may actually be deflationary since it reduces the interest on bonds (US Treasuries) that provide income for savers and other fixed-income investors. Some analysts put the amount of potential savings lost due to QE in the neighborhood of $400 billion, which represents about half of all the money spent on Obama's fiscal stimulus called the American Recovery and Reinvestment Act of 2009. Naturally, the loss of this revenue has only added to the sluggishness and stagnation of the US economy.

Economist Frances Coppola believes that QE is "deflationary rather than inflationary," and makes the case in a recent post on her blog titled "Inflation, Deflation and QE":

"Both UK and US governments believe that monetary tools such as QE can offset the contractionary impact of fiscal tightening. But this is wrong. Fiscal tightening principally affects those who live on earned income. QE supports asset prices, but it does nothing to support incomes. So QE cannot possibly offset the effects of fiscal tightening in the lives of ordinary working people -- the largest part of the population. In fact because it seems to discourage productive corporate investment, it may even reinforce downwards pressure on real incomes. And when the real incomes of most people fall, so does demand for goods and services, which puts downward pressure on prices, driving companies to reduce costs by cutting hours, wages and jobs. This form of deflation is a vicious feedback loop between incomes, sales and consumer prices, which in my view propping up asset prices can do little to prevent." ("Inflation, Deflation and QE," Frances Coppola, Coppola Comment)

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Mike is a freelance writer living in Washington state.


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