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Friday, March 5, 2010

More on Inflation or Deflation

Interesting and well researched and writtern article (selections below) from the WSJ  

It reinforces the points I made in my blog entry that reviewed some basic macroeconomics and the prospects for inflation. It seems that when one uses the broader measure of money supply that not only is the "V" in the MV +P (money supply x vellocity = price level) quite low, the M isnt growing much either. That's because the money the fed is taking onto its balance sheet in the form of securities purchases from financial institutions. But that money is not going into the system in the form of loans. It may be due to tight credit conditions by lenders or lack of demand for borrowers. But either way at least for the foreseeable future the threat is more deflationary than inflationary.

 My comments in blue

Why Inflation Hawks Should Stand Down

by Kelly Evans

No amount of huffing and puffing can inflate a leaky balloon.(puffing on a eaky baloon or pushing on a string (keynes' term) simply easing monetary policy doesnt cause inflation)
The Federal Reserve's balance sheet has swelled to record levels amid the credit crisis, prompting concern that sharp U.S. inflation is soon to follow.
But in spite of the Fed's bulging balance sheet, the nation's money supply is barely growing. That makes the prospect of near-term inflation less likely.
On Thursday afternoon, the Fed is due to release its latest weekly balance-sheet report, expected to show a small uptick from its prior $2.3 trillion level to a record high. To put that in perspective, the Fed's balance sheet was running around $800 billion before the credit crisis.
The Fed's holdings have soared over the past two years as policy makers opened a variety of emergency lending facilities, then embarked on a $1.25 trillion program to purchase mortgage-backed securities.
These holdings could present the potential for inflation down the road as they are deployed in the economy. But right now, the system has sprung a leak.....

"It shows there isn't actually a lot of liquidity out there, contrary to popular belief," says Paul Ashworth, senior U.S. economist at Capital Economics. "It's not a good sign of healthy economy."
The problem is twofold: The credit that serves as the lifeblood of the U.S. economy and helps create money is still in short supply, and demand for it is still weak.
That raises the risk of deflation in the near term, not inflation. Indeed, core consumer prices fell in January from the prior month for the first time in 28 years.
The silver lining is these conditions also give the Fed more leeway to keep interest rates low for longer without stoking inflation. For now, inflationary fears look overblown.

And in an earlier post I mentioned what Mr. Market is saying about inflation prospects. An update on that one(wsj). Mr. Market also seems to be reading tea leaves like the ones described above and when it puts real money on the line is betting inflation is not likely in the foreseeable future. If the academic theory of monetary economics in MV=P is too esoteric, skip that and look at where people are putting real money in the's not on positions that anticipate high inflation. My bolds and blues below

TIPS Market Signals Fed Rates Can Stay Low

A closely watched gauge of inflation expectations is telling the Federal Reserve that it can leave rates low for a while to help the economy heal.
The five-year, five-year forward breakeven rate--that is, the market's expectations for inflation between 2015-2020--has come down sharply since February and currently implies an inflation rate of 2.60% for that period. That's down 0.30 percentage point from the historic high of 2.91 percentage points on Feb. 1, which implied an inflation rate of 2.91%. 
Note that even that historic high cited above is incredibly benign. A level of 2.91% is still within the Fed's long term inflation target of 2 -3% and hardly a level that brings forth visions of Zimbabwe or Weimar Germany with wheelbarrows of money being brought to the grocery market

That's a good sign for the Fed--which is charged with both promoting stable inflation and maximum employment--as it continues to battle a weak economy. With inflation not a pressing concern, policymakers can feel more comfortable with leaving policy loose and key rates near zero to support consumer spending and help the labor market improve.
The improvement "takes pressure off the Fed to respond to inflation expectations," said Michael Pond, a Treasury and inflation linked strategist at Barclays Capital in New York. Before February, breakevens were headed toward 3.50 percentage points, and that could have forced the Fed to talk tough on inflation or risk its credibility being challenged.
For Chicago Fed President Charles Evans the declines since last month aren't quite enough: He said Thursday that the inflation expectations implied by the five-year TIPS market remain "slightly elevated."
Longer-term inflation expectations have been creeping up since October 2009 as better than expected data helped convince investors that the recovery was picking up pace. But so far this year, the economic picture has been far more muddled and with stimulus support starting to ebb, any recovery is now expected to be a lengthy process. Consumer prices have also been tame so far this year: January data showed prices barely up from December and core inflation fell for the first time since the early 1980s.

Pond expects long-term inflation expectations to pick up again in the next few months, though not by much. He sees little imminent danger of a rise in inflation--his forecast for inflation by December is 1% from the year-ago month, down from 1.8% in December 2009. The Fed itself sees inflation by end-year at 1.4% to 1.7%.
Most Fed officials--even those who tend to worry about price pressures--have stuck to the line that the weak economy means inflation should remain under control. "As hawkish as I am, I don't see the case for the foreseeable future of significant inflationary pressures," said Dallas Fed President Richard Fisher this week.

Translation of the above: the economy is still very weak inflation prospects are low and the core inflation data for December showed deflation not inflation.  Even if one questions how much the core cpi which excludes food and energy actually represents the inflation consumers face, the data is striking, because if you compare apples to apples by comparing just the time series of that same data this is the first drop in close to 30 years. 

And this means again that few folks that look at this stuff carefully: analysts, people putting their money on the line in the treasury markets, or even folk at the Fed don't fear inflation at this point. They're all far more concerned that the economy doesn't pick up and we  hit a devastating deflationary cycle. That scenario which would include even worse unemployment and more foreclosures should be the focus of investors as well as those talking heads, rather than visions of wheelbarrows of money being needed to purchase loaves of bread, and the dollar losing purchasing power in a Zimbabwe style hyperinflation.

1 comment:

Andrew said...


I agree with you; the threat of a sustained deflationary period hasn't passed yet. The FOMC is prudent to keep an eye on signs of inflation building, but we need to be careful not to fall into the trap of thinking that inflation is the only concern.

2009 represented the first average-on-average deflation since 1955. While my personal opinion is that we probably will have very low inflation (in the 1-2% range), I am not ruling out a chance of slight deflation and I would certainly bet on a few months of it.

I also think part of the problem is that many people don't see the evil in deflation. Intuitively, inflation is an easy evil to understand. (Or at least more ingrained in our society.)

Great article!

Andrew Matuszak