Is the US economy facing disinflation in extremis?
Or is deflation really upon us?
And how would the Federal Reservereact if it believes we face rampant deflation?
Deflation is a downward spiral of falling wages and prices and a consensus that declines will persist. And because overregulation is effectively deflationary, any such downturn can be aggravated by government rules and regulations written in pencil not pen.
Yes, low sub 3% ten-year Treasury note yields should be considered a warning shot that the bond markets are pricing in deflation. But this is more a flight to safety, a safe haven issue in the world markets.
We might instead be in disinflationary times, as prices for goods and services are still rising. Wages grew again year on year in March, consumer inflation expectations rose in May, and commodity prices are still robust.
In 2008 key indices of commodity prices dropped about 60% and have retraced only a third of that decline. That retracement stopped in and around January.
Housing costs, too, specifically rental costs are still inflationary. Rent costs have a heavy hand in the CPI, that cost makes up 40% of core CPI. The Labor Dept. uses what homeowners would pay to rent their homes instead of mortgage costs. As homeownership has fallen out of favor in the US, rent prices could be set for a longer term rally, says Barclays Capital.
It says CPI shelter costs could post year on year gains of nearly 2% by year end. That would put significant upward pressure on both the core and overall CPI.
But haven't prices for retail goods dropped? Yes, but that's because for years the United States has been importing deflation in the form of cheap Chinagoods, which has kept the overall inflation rate low. That's a dollar-yuan currency peg issue, however.
So what will happen if the Fed believes deflation is upon us?
A big kahuna of quantitative easing that will make the Fed's recent moves look like a piker, and will create hyperinflation. Meaning: deflation tautologies at the Fed will hasten frenetic, panicked monetary intervention, increasing the odds of hyperinflation.
That deflation/more QE scenario is now being encouraged by inflation hawk James Bullard, president of the Federal ReserveBank of St. Louis, who surprisingly said recently that because the US faces Japan-style deflation, quantitative easing needs to be ramped up, meaning much more Fed purchases of Treasury securities.
By how much? Moody's Analytics Mark Zandi says that, because he sees a one in three chance that deflation will be accompanied by a recessionary double dip, the Fed may be forced to resume QE on the order of central bank purchases of maybe $2 trillion or more of securities, doubling its balance sheet from the current $2.3 trillion.
And Fed chairman Ben Bernankehas already said in a 2002 speech: "The US government has a technology, called a printing press, that allows it to produce as many US dollars as it wishes at essentially no cost."
Societe Generale's perma-bear Albert Edwards said the "the coming deflationary maelstrom will be additional money printing that will make the recent QE seem insignificant."
Meanwhile, despite the central bank's monetization of about $1.7 T of government and Fannie and Freddie debt, imputed M3--which is a key measure of money meaning credit supply--has drifted south. Once that money, on top of the expected extra round of QE, is unleashed in the markets, you will see too much money chasing too few goods, which is inflation.
Peter Boockvar, equity strategist at Miller Tabak also not only says deflation is not upon us, he dismantles the current monetary policy towards battling what the US central bank sees as incipient deflation:
"With Treasury bond yields at, or near historically low levels on one hand, but with commodity prices near eight month highs; and, with the personal feeling that outside of a home, a computer and a flat screen TV, the cost of living seems to only go higher on the other hand, here is another perspective on the inflation/deflation debate."
"Since June 1981, when [former Federal Reserve chairman Paul] Volckerstarted to lower interest rates from 20%, as high inflation rates started to fall, the absolute level of CPI rose 142% to the high in July '08 (90.5 to 217)."
"Deflation is defined as a decrease in the general price level of goods and services; but, to quantify the current fall in prices, the CPI has fallen just 1% from its all time high."
"This tiny price move, notwithstanding we are still near an all time high in the daily cost of living, has led to talk that the Fed needs to do more to avoid deflation at all costs and thus create inflation via more QE (quantitative easing ). An example, oil goes from $50 to $85 in one year and the next year falls 1% to $84.15 and we're told there is deflation and deflation is bad."
"The view is that with excess capacity and a lack of demand combining for softer prices, we must have even lower interest rates to spur more borrowing and thus more economic activity to increase demand and thus reduce the large output gap."
"Think about this, policy makers think we should raise the cost of goods and services in order to cure a lack of demand. The law of supply and demand says lower demand must be met by lower prices in order to get to the proper equilibrium."
"What the Fed really wants to do is create inflation in order to not deal with an overleveraged economy in the most responsible way, either paying debt off or writing it down. They want us to pay off the debts with inflation."
"Inflation is a hidden tax on every single one of us and thus the corollary to deflation is a tax cut. Inflation is good for those who are highly indebted, as those debts get paid back with inflated money while deflation or flat prices are good for those who save and have little debt and vice versa."
"In the state of deleveraging the US is in, where the low cost of money doesn't matter much to an individual or a business in making spending and investment decisions, artificially low rates mostly spur just refinancing and higher commodity prices."
"While maybe, or maybe not, higher commodity prices make their way into government consumer price statistics, the commodity inflation is still there and has to be eaten by someone. Food for thought."
What's the better route? Bernanke in his 2002 speech noted tax cuts are "essentially equivalent to Milton Friedman's famous ‘helicopter drop' of money." He said: "The effectiveness of anti-deflation policy" is linked to a "broad-based tax cut, and open-market purchases" of government securities, (Helicopter Ben is really Tax Cut Ben.)
Here's more on the deflation debate from Jeffrey D. Saut, managing director, Raymond James & Associates:
"Currently, however, deflationary concerns are swirling on the "street of dreams;" and, I don't believe them. I think the present-day policies will actually prove inflationary."
"While it's true transfer payments to middle/lower-income recipients are not going to be all that simulative (or inflationary) given falling housing prices, that still does not spell deflation."
"In such an environment recipients will probably not spend the transfer payments, but rather save them to offset the negative wealth effect of lower housing prices. [EMac note: Which is what the University of Michigan found happened with, for example, the Bush tax rebates]."
And here's Saut weighing in on what he says is the most effective kind of government stimulus to create jobs:
"A better strategy would be making ‘transfer payments' to a program like the WPA of the 1930s. Recall, the Work Progress Administration was crafted in 1935 to employ the unemployed with the objective of putting people back to work by building infrastructure projects."
"Such operations have a far greater ‘multiplier effect' (for every $1 spent you get a $2+ impact) in the economy. Accordingly, given the current economic policies, the nascent economic recovery is likely to be slow, but with no double dip. And, that what's happening as the recent economic reports have softened, punctuated by last Friday's ugly employment numbers. Nevertheless, the economy will recover with inflation (not deflation) likely to follow."
So where is the stock market headed, despite what Saut and Boockvar believes are policy errors? Saut says:
"Clearly, the stock market believes an economic recovery lies ahead as the S&P 500 has rallied ~83% from its March 2009 ‘lows' into its April 2010 ‘highs.' Since then we have experienced a typical correction accompanied by cries that this was merely a rally within an ongoing bear market.
"Ladies and gentlemen, since the first Dow Theory "sell signal" of September 1999, I have opined the equity markets were likely going to be in a wide-swinging trading range for a very long time that would be characterized by numerous tactical bull and bear markets."
"I likened it to the 1966 - 1982 affair whereby the DJIA went nowhere for 16 years, but within that trading range there were 13 skeins where the senior index rallied, or declined, by more than 20%. I still think that is the kind of stock market pattern we continue to face."
"I also believe the March 2009 lows will not be breached. Again, looking at the 1966 - 1982 sequence, the nominal stock market low of 574 (basis the DJIA) was registered in November of 1974, while the ‘valuation low' came eight years later during the summer of 1982 with the Dow selling at 7x earnings, below book value and with a yield approaching 7%. The point is that the November of 1974 price-low was never breached! I think that is the case here in that the S&P's price-low of 666, recorded in March 2009, will not be violated."
"Speaking to stocks, I was interested to see a number of the names I have been using make it into a list compiled by Jim Grant of Grant's Interest Rate Observer."
"To make said list, a company had to be U.S. domiciled, have a market capitalization of more than $5 billion, a return on equity of greater than 15% (for the latest fiscal or calendar year), a dividend yield greater than 2%, a debt-to-assets ratio of less than 35%, and a price-to-earnings ratio of less than 15. These are the names from Raymond James' research universe that made the grade: Exxon Mobil (XOM/$61.97/Outperform), Walmart (WMT/$51.79/Strong Buy), Johnson & Johnson (JNJ/$59.96/Outperform), Intel(INTC/$20.65/Outperform), Abbott Labs (ABT/$50.57/Outperform), Aflac(AFL/$50.75/Outperform), Chubb (CB/$53.76/Outperform), Diamond Offshore (DO/$66.43/Market Perform), and Darden (DRI/$41.82/Market Perform). For the complete Grant's list please contact the Research Liaison Desk.
The call for this week: The earning's yield (E/P) on the S&P 500 is currently 6.6%, which is the highest in 15 years, while the spread between the earning's yield and the 30-year Treasury Bond is the widest in 30 years. Accordingly, I favor the strategy of buying high quality, dividend paying stocks combined with special situation income funds like Putnam's Diversified Income Fund (PDINX/$8.10). Last week the DJIA tested, and held, support. Meanwhile, the Transports are trying to break out to the upside. All of this should lead the equity markets higher."