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Deflation a Victim of Bad Press?



December 16, 2013 – Comments (4)

Board: Macro Economics

Author: FastMike

”… I never looked at prices when the going was good but now I have to… …when prices go down like this, it encourages you to buy something even if you don’t really need it.…”----63 year old Madrid Housekeeper Henar Fuentes

Dear penny-pinched Fools:

Is Deflation a victim of bad press?

Nobel Laureate, Professor Paul Krugman, heralds the dangers of deflation in this 2010 NY Time blog: ”...when people expect falling prices, they become less willing to spend, and in particular less willing to borrow. After all, when prices are falling, just sitting on cash becomes an investment with a positive real yield... ... and anyone considering borrowing, even for a productive investment, has to take account of the fact that the loan will have to repaid in dollars that are worth more than the dollars you borrowed...” --- WSJ

That is pretty much what we immediately think of when we hear the word deflation.

To the contrary though, consumers have been spending and have been borrowing as prices declined, as last Thursday’s Retail Sales Report indicated.

Let’s connect a few dots.

”...Nakisha Bishop took out a loan to buy a $23,000 Toyota Camry and pay off several thousand dollars still owed on her old car. The key to making it work: she got more than six years—75 months in all—to pay it off… ..."I had a new baby on the way, and I was trying to keep my monthly payment a little bit lower to help afford child care"..… Rising new-car prices and competition among lenders to attract borrowers is pushing loans to lengthier terms. In part, banks see the longer terms as a way to attract buyers…17% of all new car loans in the past quarter were between 73 and 84 months and there were even a few as long as 97 months. Four years ago, only 11% of loans fell into this category.”---WSJ

Now, recall the ‘shock’ this 2011 revelation caused: ”… About 97.3 million Americans fall into a low-income category.. ..together with the 49.1 million who fall below the poverty line and are counted as poor, they number 146.4 million, or 48 percent of the U.S. population…”---Huffington Post

These statistics would indicate that the cost of living is barely in reach for 33% the population and out of reach for 16%! Or another way to look at it is that nearly half of the population has little to no ‘discretionary’ purchasing power.

Lastly, the ‘Personal Income and Outlays’ report released along with the December ‘Employment Report’ noted that:

”...Overall consumer spending picked up a bit as expected at the beginning of the fourth quarter but not by much, to plus 0.3 percent in October vs plus 0.2 percent in September. Strength was in durable goods reflecting strong auto sales. Smaller gains were posted for nondurable goods and services…..The income side of the report is especially soft, at minus 0.1 percent following two very strong months at plus 0.5 percent. The decline is the first since January and may be related to the impact of the government shutdown on private wages. Wages & salaries are especially soft, up only 0.1 percent following gains of 0.4 and 0.6 percent in the two prior months…”---Bloomberg

There’s a picture forming here. A high percentage of consumers have declining wages and benefits, face artificially inflated prices and are compensating for it by stretching credit.

Jim Cramer of “The Street” summed it up quite well:

”…When you look at last week's earnings reports from many retail-oriented companies the message is clear that consumers on Main Street have significantly cut Back spending…the Federal Reserve wants a higher inflation rate, while Main Street struggles with a higher cost of living… …Savers earn zero on their money and these folks never invested in the stock market and never will. Interest rates are significantly higher on consumer credit cards and on small business lines of credit. The bottom line is that Fed policy has failed to help Main Street and recent earnings from retailers support this notion.” --- The

He’s right. Think about this: doesn’t it seem absurd to have on one hand an inflationary monetary policy and then on the other, legislation trying to increase or extend unemployment benefits, food stamps and minimum wages so that consumers can keep up? QE is indeed keeping prices stable and employment is increasing but only at the ‘expense’ of wages, income and compensation.

Large corporations and private equity are not to blame. They’re doing exactly what they’re supposed to be doing. They’re taking advantage of the opportunity: employing low cost capital to strengthen productivity, cash flow, dividends and stock price in the most efficient way possible. That’s the way the system is supposed to work. They are exercising their ‘animal spirits’ while being fed by the Fed.

Unfortunately, the unexpected consequence, or Black Swan if you will, has been that these ‘animal spirits’ generated better returns with fabulous efficiency by methods that completely bypassed, or even resulted in negative side effects on the larger economy. The most notable example is how the reflation of the housing bubble drove up rental prices:

”...Half of all U.S. renters today pay more than 30 percent of their incomes on rent. That's up from 18 percent a decade ago, according to the Harvard center. For those in the lowest income brackets, the jump is even worse…”---NBC

The Fed is not ‘entirely’ at fault, but only to a point. They have stated clearly and many times that the transmission mechanism for liquidity injections is very imperfect. However, the Fed has certainly underestimated how sophisticated global financial networks have become as evidenced by a relentless increase in asset prices, like stocks, bonds and commodities while the 'new normal' economy bumped along.

Could it be that QE is not suited for every situation?

Economist Angel Laborda of Funcas(Sp.) has observed that the recent EU dip into deflation resulted in: ”… nothing but benefits.. ..prices are finally reflecting lower income and it is stimulating demand…”--- Bloomberg

Whoa! Deflation stimulating demand!? As stunning as it might sound, Laborda observed it right! Consumers simply don’t or can’t wait in a modern economy.

And this is the key point.

Why keep fighting deflation? Through its extraordinary capabilities the Fed has been able to keep the dollar ‘above water’ for five years now. That being so, if the Fed ‘eased up’ just a bit on QE, wouldn’t that create across the board purchasing power for a significant portion of consumers who must use it?

Listen to Professor George Selgin, Senior Fellow, Cato Institute in this CNBC Europe video (about 8 minutes).

Professor Selgin makes sense. One glance at ‘money velocity’ data for the past few years is proof enough that QE certainly doesn’t create ‘wholesale’ demand.

QE may not be an efficient solution in a 21st century economy; the belief that it is a "cure-all" has become too monolithic. The proof is clearly seen in the segment of the economy where it should have created rivers of capital liquidity. Instead it has created a drought. An equally monolithic belief that deflation is to be abhorred is standing in the way of a possible solution: creating purchasing power with the income of nearly 150 million consumers who must spend, or must use credit, in particular, by increasing purchasing power with money already in hand.

The great QE unwind is bound to happen and the big question is: will the economy remain unchanged in a new normal, will it end this slow recovery, or as contrary as it might sound could there be a sudden across the board acceleration?

There is a good case to be made, along recent evidence, that a strengthening dollar might unleash a surge of both discretionary and non-discretionary spending at a rate fast enough to clear inventory and require increase production throughout the economy.

It might even create a shift in the negative perception of deflation: monetary easing is only one-half of a successful recovery policy. In particular price stability might be better achieved through price flexibility rather than through monetary easing only.

A policy with which I am certain Señora Fuentes will agree.

Your pensioned Fool,

4 Comments – Post Your Own

#1) On December 17, 2013 at 1:48 AM, awallejr (38.58) wrote:

Nice argument.  Much merit if whether deflation is good or bad.  I suppose it depends on one's point of view.  You would think from a consumer's point of view (main street) it would be good. And from an investor's (wall street) point of view not so good.

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#2) On December 17, 2013 at 7:43 AM, Repurposed (< 20) wrote:

Great post! The danger in loss of fed infuence seems to be:

1) decline in money velocity to a negative;  Professor Fuentes' argument may unintentially include this;

2) no new money chasing asset values and the last fool out of the market turns out to be the retail investor (that's me).

3)  Captal markets that have grown lazy from federally guaranteed "puts" who don't remember how to provide mortgages with real "at risk" money (this has happened in many condo markets);

4) Big business realization that those great margins and stock prices are born from doing less rather than any innovation or increased market share;

5) Greater business tightening meaning even fewer jobs.  As pointed out, SOMEONE has to buy things and it's becoming an increasing smaller pool.

6) Emphasis on job growth.  Higher taxes.  Lower margins.  Lower stock prices.  Lower dollar.  Recession.  It seems like 2008-2009, when all this easing began.

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#3) On December 17, 2013 at 10:37 AM, awallejr (38.58) wrote:

It seems like 2008-2009, when all this easing began.

That is because nothing has really changed to warrant a tightening yet.  The FED can only do so much.  For years Bernanke has been asking help from the fiscal side and just never gets it.  Congress is simply broken.

The Republican party of today is no longer the party of my Parent's back in the 1940s and 1950s nor of Reagan's back in the 1980s.

The Democrats just simply love to spend and force paternalism onto everyone.

Grover Norquist took the word "compromise" away and replaced it with "common ground."  Listen to Republicans, they don't say "compromise."  Problem is when you do that you can only get small little deals made.

I will give Boehner a little credit for showing some backbone against the PACs, but until they are reigned in (and might take a Constitutional Amendment to do so) I don't see much promise for Main Street.

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#4) On December 19, 2013 at 11:54 AM, MoneyWorksforMe (< 20) wrote:


First I would like to say that I really enjoyed this post; it was very well thought out and put together.

 I understand your point. I think this notion of choosing deflation as opposed to inflation, makes sense, at least on the surface. My suggestion, however, is this: neither deflation nor inflation are a panacea, and if we continue to consider monetary policy in this way we will continue to be VERY dissappointed in the long term results. I'm afraid the US economy is being plauged by very significant structural problems, from education to taxes, that have been put off for far too long. The US economy has lost a great deal of competitiveness for this reason, and will continue to do so until these problems are rectified.

As an aside here are two other points to consider: 1.)I think it's convenient for the largest debtor nation in the world to choose an inflationary monetary policy vs. deflationary. Would I like to devalue my enormous debts or increase them? A very simple question for an individual, should one ever be able to make the choice...2.) QE affects interest rates, as you noted. But there are two aspects to this: a.) Make borrowing "cheaper" -- "stimulate" lending - as you covered. and b.) Suppress/Limit the percentage of government revenue that would be going strictly to debt issuance. This is paramount to government solvency (or at least the appearance of it). See Japan. What would rates look like if the fed were not buying bonds? How would this affect the picture of the government being able/unable to satisfy its debts. Japan cannot end QE for this reason alone. Is the same true for the U.S.? The markets would surely demand a much higher rate without the fed involved. What does this picture look like if rates revert back to the historical mean of 6.5% on the 10yr...Now that's a scary thought...You get the picture...So perhaps QE is mostly about government solvency, and less about "lending" and "spending"...

Thanks again for the though-provoking post...I look forward to more...

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