Which is Stronger- Inflation or Deflation?

By Tim McMahon, editor

Why the Printing Press is No Match for Deflationary Forces-

A mere two years ago (although it seems like a lifetime) in August of 2008, inflation was roaring in at 5.37% and the world was talking about hyperinflation.  But then along came the housing crash which started the domino effect of deflationary forces.  Housing prices, stock prices, asset prices all began falling; triggering margin calls and more liquidation until even Gold (the only investment that is not simultaneously a liability) began to feel the deflationary pressure.  By July 2009 a mere 11 months later, everyone was no longer afraid of the inflation monster, but now they were fearing deflation. At that point the inflation rate was negative (deflationary) at -2.10%, a rate of deflation we hadn’t seen since the 1950’s.

The government was so afraid of the “asset deflation domino effect” that they opened the liquidity spigot full blast and created a Trillion dollars out of thin air. This temporarily reignited hyper-inflationary fears.  But as I said in my article Velocity of Money and Money Multiplier- Why Deflation is Possible  as the velocity of money falls, money isn’t turning over as fast and it stops multiplying. So even with the government spigots wide open the money supply can still contract.  And so even though the inflation rate  initially rebounded to 2.72% by December 2009, thereafter it began to slowly drift lower again.  Velocity of money and the money multiplier were doing their work slowly eating away at the inflation rate, from 2.14% in February, to 2.02% in May, to 1.05% in June.

So now investors are beginning to see the picture I painted back in April in my “Velocity of Money and Money Multiplier- Why Deflation is Possible article” and investors don’t like what they’re seeing.

So what is keeping the inflation monster at bay?

It’s a lack of demand pure and simple. With prices falling and the job situation precarious who’s going to go get a bigger loan? And even if they wanted to because they felt  “money is cheap” they still have to qualify for the loan.  And banks are being very cautious these days.

That brings up a key point… Deflation in itself isn’t bad. What consumer will complain about falling prices? Even producers don’t mind falling prices for their supplies, although they don’t appreciate not getting their asking price when selling their products.  But what is even worse, than small margins is when deflation results in low demand for their products. Remember we said buyers are reluctant to buy anything other than necessities.  Now is not a good time for sellers of non-necessities!

So lack of demand hurts profits and causes falling corporate margins, and usually weaker wages. Both are bad for business, which is why companies fear deflation (or more accurately they fear the results of deflation).

To see a modern example of what deflation can do to an economy you don’t have to look further than to 1990’s Japan.  The similarities are staggering… sky high real estate prices crashing down?  Check. Too much debt? Check. Rising Unemployment and falling incomes? Check. It’s all been seen before…

So what’s the Fed to do?

The FED can’t lower interest rates below zero so, Bernanke & Co. opted on Tuesday to boost the economy by injecting a little liquidity into it. Not too much now… just enough to create a slight drop in long-term interest rates (especially mortgage rates) to prod consumers to buy more than they really want to at the moment and keep the economy from stalling.

After the Trillion dollar injection last year how much effect will $10 billion have?

$10 billion injected into the economy over several months isn’t much.  The M1 level (all cash plus checking accounts) is around $1.7 trillion; so $10 billion is about ½% of the smallest measure of the money supply and even less if you calculate it on the more inclusive M2 or M3.

In a high money-multiplier environment such an injection would have a measurable ripple effect. But with a multiplier below 1, it may have no effect at all.

So what exactly is the problem? It’s not a lack of cash… there’s already a huge amount of cash in the public’s hands.  According to Moody’s, U.S. non-financial companies have the highest  percentage of total assets in cash in over half a century with $1.84 trillion in cash, add in Hedge funds $450 Million in cash and that brings the total to over $2 Trillion.

And it’s not just companies with cash, add in the almost $1 trillion in money-market funds that American Households are holding and you have $3 Trillion sitting in cash. The problem is people just don’t want to spend it (or risk it). With everyone living from paycheck to paycheck the slightest fear about the availability of that next paycheck and the reality of your situation comes quickly.  Better put off the purchase of that new Flat Screen TV (or that risky stock) for a bit.

So will a little extra liquidity change the public’s mind?  Maybe… depending on the jobs situation.  If John Q. Public feels his job is secure and the unemployment rate begins dropping people will become less risk averse.  But until that perception changes the multiplier will continue to divide instead of multiply and deflationary forces will prevail.

See Also:

• Pushing on a String, Velocity of Money and Money Multiplier Conspire Against the FED
• Is Ben Bernanke “Shooting Blanks”?
• Deflation or Inflation? Yes.
• Why Deficits Are Politically Convenient
• Deflationary Forces Overpower FED