“The world’s biggest problems are the world’s biggest business opportunities.”
– Peter Diamandis
One pill makes you larger
And one pill makes you small
And the ones that mother gives you
Don't do anything at all
Go ask Alice
When she's ten feet tall
When logic and proportion
Have fallen sloppy dead
And the White Knight is talking backwards
And the Red Queen's off with her head
Remember what the dormouse said
Feed your head
Feed your head
– “White Rabbit,” Jefferson Airplane, 1967
Will they or won’t they? Next week the Federal Reserve might raise interest rates. Many of Wall Street’s worker bees have never seen a rate hike. They were still in school (or skipping school) when the Fed last tightened in 2006.
As readers know, I believe the Federal Open Market Committee should hike rates ASAP. A number of very astute analysts and Fed observers agree with me. On the other hand, an equal-sized army of similarly smart analysts think they should not. It seems to me this recovery is getting long in the tooth. The Fed needs to give itself some room to stimulate when the economy turns down again. As it stands now, its only weapons are to take interest rates negative or to resume quantitative easing. We don’t want either of those.
Further, I don’t think there is any question about the potential for malinvestment and distorted economics at the zero bound.
What I think matters much less than what the FOMC’s voting members think, of course. Their public statements mostly seem dovish, but the voters always leave themselves plenty of wiggle room. If you are confused, don’t feel alone. Larry Meyer, former Fed governor and as close as there is to an insider on Fed policy, is pretty well split between a “liftoff” in September or one in December. I was reminded by Bob McTeer, former Dallas Fed president, when we did a panel together this week, that if they raise rates to 0.25%, the effective rate will be much less for this first round.
If they don’t hike rates, the reason may be that they don’t see the kind of inflation that tighter policy is supposed to stop. Specifically, the Fed sees upward wage pressure as a key indicator that inflation is taking hold. Hence the recent obsession with all manner of wage and income statistics.
Even if the Fed sees enough inflation to raise rates, I don’t think the cycle will last long. And thus we come to this week’s topic. I am asked all the time whether I think we will see inflation or deflation in our future. Most of the time the people asking the question are looking out 6 to 18 months. Today I’m going to answer that question, but we’re going to look out 5 and then 20 years.
We now live in a world of relentless deflationary pressure. Very large forces are behind this, and I don’t believe it will change. If anything, the trend will strengthen.
That is not to say a determined central bank cannot create inflation. But just as Paul Volcker and then Alan Greenspan had to fight a general tendency toward inflation, which brought us to a period of disinflation, the Fed and other central banks in the developed world will be dealing with a deflationary tendency.
The Fed’s statutory mandate isn’t simply to stop inflation; its charge is to maintain price stability. Inflation is not price stability, but neither is deflation. The Fed is supposed to keep both at bay.
Volcker, who stamped out the 1970s inflation cycle with aggressive rate hikes, would be bored out of his skull if he were leading the Federal Reserve today. No one needs his inflation-busting skills. In fact, it would take a major policy error on the part of the Federal Reserve before we would ever need him again.
In the coming years, though, we may well need an inverse Volcker.
Is deflation really so bad?
Today most people accept inflation, even if they don’t like it. We think of it as background noise. Inflation is always there, more or less, so we make adjustments and then tune it out.
Life under deflation is not at all like life under inflation, and most of us lack the analytical framework to deal with deflation. It doesn’t compute. Financial analysts who can make inflation adjustments in their sleep have no idea how to adjust their models to reflect deflationary risk. They had better learn.
We need to stop right here and recognize that what I’m going to be talking about today is price deflation. That is a different animal than monetary deflation. One we like; the other we don’t.
Deflation doesn’t sound so bad if you think of it as an environment of generally falling prices. Everyone loves a bargain. The problem is that your salary is simply the price at which you sell your labor. That price can fall, too. If the price of your labor falls faster than the prices of everything you buy, you can find yourself in deep trouble very quickly. Think that can’t happen? Ask the Greeks. Or any of your neighbors who lost their jobs in the Great Recession and subsequently took jobs at lower wages. Deflation at work.
Deflation also isn’t fun if you’re in debt. If prices are generally falling, you have to repay your debts with dollars that buy more than when you first borrowed the money. Just as inflation is the debtor’s best friend, deflation is the debtor’s worst nightmare.
Deflation would be as “normal” as we currently perceive inflation to be if we had a fixed money supply. Each currency unit (gold or anything else) would naturally buy more as people produced more goods and more offspring. Bitcoin will be massively deflationary if it ever gets off the ground. In fact, that is one of my major criticisms of Bitcoin. It carries the same deflationary weakness as gold does for a modern world. It heavily favors incumbents and the rich. A properly structured and managed electronic currency – Milton Friedman’s computer running the central bank –would be truly neutral.
Now, of course, we don’t have a fixed money supply; we have a very dynamic money supply. We have central banks continually trying to exert influence, almost always in favor of their home countries to the potential detriment of the rest of the world. Consumers have influence as well through their spending and saving decisions.
Most of the world’s central banks are now trying to inflate and debase their currencies, while most of the world’s consumers are unwittingly stoking deflation. I feel very confident consumers will win this standoff, but when and how they will win are open questions.
Ultimately, we are going to have our cake and then be forced to eat it. We’ll get the low prices we want and demand, and we’ll get the consequences as well.
Good and bad deflation
My first economics mentor, Dr. Gary North, drilled it into my head that ever-lower prices are the natural result of a market economy. As people learn to produce more with fewer resources, competition, especially in the form of Schumpeter’s creative destruction, forces prices downward. In a truly free and competitive market, it is only the debasement of the currency that allows the conditions for prices to rise. All things being equal, if the price of something is not falling over time, it raises my suspicions about competitiveness. Think OPEC in the latter part of the last century. OPEC nations are losing their control today as the rest of the world, and especially the United States, becomes more competitive in the production of oil. While it took a long time, the cure for high energy prices was high prices. An enormous amount of money was invested, not just in the search for oil but also for lower-cost ways to produce it.
As an aside, the current price of oil, even though it is 10 times higher than it was before OPEC was formed, is only a little bit above its inflation-adjusted long-term average. Look at the chart below. The red line shows oil prices adjusted for inflation in March 2015 dollars. The black line indicates the nominal price (in other words the price you would have actually paid at the time). The price as of April 30 is $52.50 a barrel, down significantly from recent highs but still above the average inflation-adjusted price of $41.70 for the period from 1946 to 2015. It’s a little hard to see, but the red line showing inflation-adjusted prices has dropped right along with the black nominal-price line. With oil currently in the mid-40s, we are almost exactly at the long-term inflation-adjusted average of the past 69 years – and certainly lower than the last seven or eight years.
Gary Shilling wrote the book on deflation, literally called "Deflation." It was written in 1999; and if you want more information on the topic, I would recommend that you read his later book, "The Age of Deleveraging, Updated Edition: Investment Strategies for a Decade of Slow Growth and Deflation."
What Gary shows us is that, other than for nations in debt, deflation is not only a natural state but is something to be desired. There have been periods of “good deflation” throughout history. The “bad deflation” that we especially associate with the 1930s comes from the twin evils of too much debt and leverage plus monetary policy mistakes. The bursting of a debt bubble always and everywhere produces “bad deflation.” Bad deflation is monetary deflation, and it is devoutly to be avoided. When economists and central bankers talk about their worries over deflation, they are referring to monetary deflation, not price deflation. Just for the record, I concur with their worries.
continue reading: http://www.mauldineconomics.com/frontlinethoughts/needed-at-the-fed-an-inverse-volcker
