Inflation and Deflation, A 21st Century Paradox

Because in the real world they’re shuttin’ Detroit down,
While the boss man takes his bonus pay and jets on out of town,
D.C.’s bailing out them bankers as the farmers auction ground,
Yeah while they’re living up on Wall Street in that New York City Town,
Here in the real world they’re shuttin’ Detroit down.

A popular Country song by John Rich


“The first panacea for a mismanaged nation is inflation of the currency; the second is war.  Both bring a temporary prosperity; both bring a permanent ruin.”   Ernest Hemingway

 “If Americans ever allow banks to control the issue of their currency, first by inflation and then by deflation, the banks will deprive the people of all property until their children will wake up homeless.” Thomas Jefferson, U.S. President 1801-1809


A few days ago, a long standing client called our office and asked the following question, “Are we in an inflationary or deflationary environment?”

My answer, “We are in both.”  Since the fall of 2007, we have witnessed deflation in the form of falling asset prices in housing and the stock market.  Also there has been a collapse in the prices of many other financial assets.  On the other hand, we have been subject to monetary inflation in the form of a massive infusion of dollars by the U. S. Treasury Department and the Federal Reserve Board through their Stimulus Packages. This may eventually lead to hyperinflation in the out years of these bailout programs.

By way of expanding the verbiage of my answer, let’s see if we can develop a forecast for the direction the economy and the stock market will take for the next few quarters. First let me lead with something from a March 31, 2009 Bloomberg article.

Mark Pittman and Bob Ivry wrote:

“The U.S. Government and the Federal Reserve have spent, lent or committed $12.8 trillion, an amount that approaches the value of everything produced in the country last year, to stem the longest recession since the 1930’s.

 New pledges from the Fed, the Treasury Department and the Federal Deposit Insurance Corp. includes $1 trillion for the Public-Private Investment Program, designed to help investors buy distressed loans and other assets from U. S. banks.  The money works out to $42,105 for every man, woman and child in the U. S. and 14 times the $899.8 billion of currency in circulation.  The nation’s gross domestic product was $14.2 trillion in 2008.”

 Can you imagine 14 times the money in circulation today?   We are looking at a very large bailout bubble, the end result being a tremendous increase in our money-supply which, in turn, can and will cause price inflation.  We will see too many dollars chasing too few goods and services.

Each and every month the U. S. Labor Department issues their estimate for inflation in this country using an index of goods and services minus food and energy.  At present this index is telling us that the inflation rate is running at a little under 2%.  If you believe that, I’ve got a few shares of Jds Uniphase Corp. we can sell you for $600 a share.

Carl Perthel, our resident statistician, along with a myriad of other tasks he performs for us, was asked what his bi-weekly shopping inflation or deflation rate has been for the past year.  He said without hesitation, “What’s with this deflation?  I’ve seen a 15% rate increase over the last year, but that includes food and energy.” O.K. there you have it. Carl is a very careful shopper and if he is seeing a 15% increase in his bi-weekly purchases, our country is beginning to fall under the inflation umbrella.  Or is it?

Be it CNBC, Fox Business or Bloomberg, the same line is heard.  And that is that the Fed’s main fight is against deflation.  There is no doubt that the winds of deflation are the primary force in the developed world today.  The U.S. has witnessed rising unemployment over the last 18 months.  Although the official U.S. Government pronouncement is 10.2% unemployed, the fact is that another 7% of the total workforce is underemployed (working at temporary assignment) plus another 3% or more have become discouraged and are no longer looking for jobs.  So the real unemployment rate is hovering around the 20% rate.  Business spending is down.  For those that do have jobs, in many cases, their wages stay flat or are going down.  Many stories have been written about companies cutting wages 5 to 20% just to avoid staff reductions.

Lending by commercial banks is back where it was two years ago.  Banks just aren’t lending.  They are using the funds they have to buy government debt to shore up their balance sheets.  No lending, no borrowing, leads to no business investment.  This is particularly true of small businesses where the majority of jobs are created.  And for big businesses worldwide, their capacity utilization is at an all time low so they have absolutely no incentive to borrow for expansion.  Until the private sector returns to health, job creation is just a myth.

Consumers are not spending; they are paying off debt.  With the stock market tumbling       between October 2007 and March 2009, along with the deflating of the housing bubble, the average American has had a rude awakening.  No longer are they willing to spend ruthlessly more than they earn.  Change is in the air, personal savings may be coming back in style.

So on the deflation side of our coin we have high unemployment, the lack of job creation and deflating prices on many consumer items.  Housing prices are still on the down swing and most popular common stocks are a long way from their October 2007 highs.   All this has us witnessing the worst recession since the depression of the 1930’s.  Our financial system, led by the “too big to fail” banks and other giants such as Fannie and Freddie, AIG and the big two titanic auto monsters GM and Chrysler, has become anemic.  As stated above, banks are not lending which leaves the government and the Fed to fill the gap by issuing gobs of debt and paper money to try and keep this recession from becoming worse.

At this juncture there is very little price inflation in our economy.  Yes, we do see price increases in many areas such as education, medical, energy, etc.  But overall our government tells us that price inflation is moderate.  O.K. we can go along with that but we are winking with one eye and have our fingers crossed.  What we are fearful of is the hooded monster hiding behind the door.

That hooded monster is named Monetary Inflation.  As defined by Wikipedia, “monetary inflation is the term used to differentiate direct inflation in the money supply (or debasement of the means of exchange) from price inflation —-.”  What is defined here is the debasement of paper money or creation on credit by our Federal Reserve System (Central Bank).  Question: Doesn’t Section 10 of Article 1 of the Constitution of the United States of America say, “No State shall – make any Thing but gold and silver Coin a Tender in Payment of debts.”  That’s after Article 1 Section 8 gives to the Congress the right “to coin money, regulate the Value thereof.”

The above chart shows the growth of the Monetary Base, or put another way, the amount of money in the economy.  It’s startling, but our monetary base has grown from 854.395 Billion in the week of 1/1/2009 to a shade under 2 trillion for the week ending 10/9/2009.  That’s over 100% growth in less than a year.  This is excessive monetary growth.

Herein lies the problem and the answer to the question on the other side of the coin, “Are we in an inflationary environment?”  Inflation is caused, for the most part, by the money supply increasing at a faster rate than the underlying economy.  Third quarter GDP was announced as having grown by 3.5%, the first positive quarter in the last five.

Ben Bernanke succeeded Alan Greenspan as Chairman of the Federal Reserve on February 1, 2006.  An academic, he was a student of the ills of the Great Depression and felt that the great mistake made by the Fed was not pumping enough liquidity into the economy during those trying years.  Also, early in Dr. Bernanke’s tenure, the government decided to change the calculation methodology for computing the Consumer Price Index (CPI) so that rising price of food and energy could be edited out.

Within his first two years in office Bernanke was met with three calamities.  First, the subprime mortgage crisis in early 2007, followed by the credit crunch in late 2007, coupled with the global stock market crash which also started in the fall of 2007.

Thus was born “Helicopter Ben” and his ability to test his theories of expanding the monetary base as the way to halt a recession before it becomes a depression.  And expand it he did with a doubling of the base in a year’s time.

Now the question of, “Why hasn’t all this new money flooding our economy caused a jump in the rate of inflation?”  First of all the changes in the methodology computation of the CPI has concealed the rapid run-up in energy and food costs.  Surging money growth is first apparent in commodity prices which have a direct effect on food and energy and they are subtracted from the official number.

More important, in this writer’s view, it has to do with the velocity of money.  Simply put, the velocity of money is the rate at which money circulates, or changes hands during a certain period of time.  The problem, today, is that the bulk of money that the government has drained from the American taxpayer and used to prop up our financial institution and auto companies has stayed with these companies.  There has been little turnover of these dollars; therefore we have seen virtually zero rate of change.  Banks aren’t lending, businesses can’t borrow; therefore, little job creation and very little growth in our economy.    In addition to “Financial American” deleveraging, we have the billions upon billions of dollars that have gone into our banks to keep the system alive.  To give our reader some idea of the magnitude of the dollars that have been salted away by the banks in the form of excess reserves deposited with the Fed, suffice is to say, that these reserves have grown from around $10 billion in August of 2008 to around $1 Trillion today.

Since institutional deposits with the Fed are not counted as monetary aggregates, they therefore are not available to be loaned to borrowers looking for money to expand their businesses.  By banks not lending their reserves the velocity of money stays at zero and the economy becomes stagnant.  This, however, will change and the borrowing window will be opened.  A close look at the 3.5% GDP growth in the 3rd quarter will find that most of that growth came about through Government spending not through private-sector employment and investment.

The two reasons for the lame CPI numbers, as stated about, can not keep inflation in tow for the long run.  As of this date the Fed is still flooding the system with dollars created out of thin air.  All this money will eventually overwhelm the system. By that it’s meant that once the banking system has healed its wounded balance sheet by shoring up their capital accounts, they may begin to open the borrowing window.  Once this happens, the flood of dollars created by the Fed will overwhelm the available goods and services causing the rate of inflation to move much higher.  So inflation is on its way, it’s just a matter of time.

What does all this mean for the stock market?  For those that have been following these web writings, you are aware that our prognostications have been very close to the mark over the last several market cycles.

We still feel that the trend of this market and our economy remains bearish at least through mid-year 2010.  If in fact, the upward move from March of this year to present has been a correction within a secular bear market; we may see the averages begin to turn down sometime before spring of next year.

The key that the stock market will be looking for will be found in the employment numbers.  Private sector job creation is most important if the economy is going to grow.  Stimulus money provided by the Government is not the answer to creating the kind of high paying jobs needed to encourage business to expand.

To understand where we are in the economic cycle it’s best to look back to the 1974 writings of highly regarded Washington University professor of economics Hyman Minsky who wrote, “A fundamental characteristic of our economy is that the financial system swings between robustness and fragility and these swings are an integral part of the process that generates business cycles.”  We are still oscillating in the robust portion of the cycle so we must be weary.  The fragility component is still to come.

Gordon B. Lamb

November 10, 2009