Do we get deflation or inflation? Today we look at the darker scenario.

Larry Kummer, Editor

12 years ago

Summary: One example of our inability to see the world through our ideological blinders is the obsession with inflation (coming real soon, so we’ve been told for 3 years) while deflation bangs on the door. We must learn to see better. Fortunately the people running the economy see more clearly (despite the mockery and insults directed at them by the ignorant and deluded), and have taken measures to defend against deflationary forces threatening the US economy. The outcome remains uncertain, however.

Introduction

Seeing the world clearly requires awareness of the full range of reasonably possible outcomes (in the far tails of the bell curve lie dragons, to discuss on another day). Those giving hysterical and insanely confident forecasts of inflation and hyperinflation are blind — and blind their fans — to the danger of deflation.

Both are outcomes are possible, perhaps sequentially.

Today we look at the analysis of one expert, Russell Napier — global strategist of CLSA.

Excerpt from “Great reset revisited”, 7 June 2013

The world has been in disinflation since 2011: deflation is next. Japan has won the currency war and its cheaper exports are forcing others to cut prices. Meanwhile, slowing growth and weakening currencies in emerging markets augur a debt crisis; and commodity prices continue to fall amid a global slowdown and rising supply. Most worryingly, both real interest rates and the US dollar are rising.

US inflation has fallen despite QE

QE is not delivering: the Fed’s balance sheet has grown by 18% since September 2011, while inflation has fallen from 3.9% to 1.1%.

The US 30-year bond yield has remained unchanged over this period: thus US real rates have risen by 280 bps {2.8%} despite QE.

US nominal rates bottomed a year ago and have risen by 83bps since then, while inflation has fallen by 33bps.

Moreover, the Treasury inflation-protected securities (TIPS) market indicates that inflation expectations are falling, while nominal yields are rising.

EM growth is slowing and exchange rates are under pressure

Weakening emerging-market (EM) currencies augur a balance-of-payments crisis, which means either lower domestic growth or lower exchange rates and defaults.

As the EM growth outlook deteriorates, global inflation will fall further.

EM foreign-currency bond prices are cracking, indicating that the large capital inflows that funded current-account deficits are ending. Japan has won the currency war and is now exporting deflation

On the back of yen depreciation, Japan is cutting its US-dollar selling prices.

Japan’s actions have forced competitors to follow suit: now Korea and China are also exporting deflation to the USA.

The Bank of Japan’s need to prevent JGB {Japanese government bond} yields from rising will mean ever greater intervention and even more deflationary pressure from a weakening yen.

… In 1Q 2009, this analyst tried to persuade investors that excessively easy monetary policy would likely defeat the expected deflation … The overwhelming response was that there was no way the creation of money could offset the negatives associated with the large surplus of supply relative to demand. There was huge scepticism that the Fed’s ability to alter this one variable could play much of a role in altering all the other ‘fundamental’ variables …

Today, things could hardly be more different. In conversations with investors, the opinion is regularly expressed that Ben Bernanke can accelerate or decelerate money-supply growth as required; stop the US dollar’s rise; halt deflation; contain inflation; and underwrite asset prices. Some also argue that he could intervene to stop a liquidity squeese in EMs and buy euros if necessary to prevent the breakup of the Eurozone.

… Financial history has some very simple and clear things to say on this subject. Central bankers can only target one variable at a time, and their track record in hitting just one target is extremely poor. Ben simply doesn’t have the power to fix all the things that can go wrong.

Excerpt from “An ill wind”, 25 November 2013

Deflationary forces are gathering strength

Prices of exports from Japan, China and Korea continue to fall.

Bank credit growth is slowing rapidly in the USA and contracting in the Eurozone.

Nestle has cut its selling prices in Europe as deflation spreads from commodities to consumer staples.

… The Fed’s desire to hold inflation expectations above 1.5% … is evident from when it chose to fight its battles. The launches of QE2, Operation Twist and QE3 all coincided with five-year-TIPS-implied inflation declining below 2.0% and heading towards or below 1.5%. These decisions to up the ante in monetary policy as inflation expectations approached the key 1.5% level were not coincidental.

QE2 in November 2010 was followed by a rise in both inflation expectations and actual inflation, while both Operation Twist in September 2011 and QE3 in September 2012 were followed by a rise in inflation expectations but a decline in recorded inflation. Thus since September 2011, the Fed has succeeding in managing inflation expectations but not inflation itself.

Has anybody noticed? What happens when they do? Will QE4 be as successful at changing even inflation expectations when QE1, QE2, Operation Twist and QE3 have failed to prevent recorded inflation from now falling to 1.1%?

… Since the launch of QE in March 2009, Solid Ground has focused on the prospect of it leading to far too easy monetary conditions in EMs and rampant inflation. Such inflation did indeed materialise and it undermined EMs’ competitiveness and brought a major deterioration in their external accounts. However the high levels of domestic inflation in EMs, particularly wage growth, did not spill out into inflation in the globally traded goods market. This phenomenon was particularly pronounced in China, where a 70% rise in wages since the launch of QE has produced only a 4% rise in the price of Chinese imports to the USA.

… the price of Chinese imports to the US has fallen throughout 2013 despite continued strong rises in wages. The most obvious source of global inflation remains contained within China where its main impact seems to be in eroding corporate profit margins rather than pushing up the general price level.

The downward pressure on globally tradable goods is occurring as commodity prices continue to decline. The decline in commodity prices began in 2011 as EM economic growth peaked. In recent weeks prices have declined again and are almost back to their recent lows of June 2013. With more evidence of a continued growth slowdown in EMs, the decline in commodity prices and the associated disinflationary impacts seem set to continue.

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