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The Great Inflation/Deflation Debate

You can’t afford to get this one wrong.

Anyone who has tuned into the financial news recently has been assailed with contradictory reports – first that deflation is the biggest risk but later that inflation is what we really need to worry about. Why is this so important?

Simple, in a deflationary environment, cash is king. Asset values such as stocks, commodities including gold and silver, as well as the cost of food, fuel and other everyday necessities fall. Deflation is the result of a drop in demand for goods as the economy slows, unemployment rises and people have less and less money to spend. Money supply, the money in circulation in our financial system, declines.

Stagflation occurs when costs climb but salaries and incomes either remain stagnant or fall. The last time our nation experienced stagflation was during the 1970s.  Squeezed between the cost of necessities and a fall in available cash, consumers spend less. Strikes increase as discontented workers rebel against falling real incomes. Price controls by government exacerbate the situation causing long lines for food, fuel and other necessities as the costs to purchase these goods falls below the cost to produce them.

Inflation occurs when an increasing number of dollars chase a limited supply of assets. Consumers rush to trade cash for goods as the price of these goods climbs. Stocks and commodities rise initially as investors increasingly seek refuge as the value of their dollars falls. But this trend is usually short-lived. Rising inflation forces responsible central banks to raise interest rates in an attempt to control the inflation dragon which will eventually lead to deflation.

Hyperinflation occurs when inflation is left unchecked because central banks are reluctant or unable to raise interest rates or reduce money supply – usually the result of populist government intervention. Instead the government tries to fix the problem by doing more of what got it into trouble in the first place. It prints more and more money until the inflation rate skyrockets. Hyperinflation has occurred periodically throughout history where a fiat paper currency has granted political leaders the freedom to print money as the mood arises.

This next news story is a textbook example of hyperinflation at its destructive worst.

Zimbabwe abandons its currency,

BBC News, January 29, 2009

“BBC southern Africa correspondent Peter Biles says the Zimbabwean dollar has become a laughing stock. A Z$100 trillion note [equivalent to $30USD] was recently introduced. Our people are now using multiple currencies alongside the Zimbabwean dollar according to Acting Finance Minister.  The country is in the grip of world-record hyperinflation which has left the Zimbabwean dollar virtually worthless - 231,000,000% in July 2008, the most recent figure released. Teachers, doctors and civil servants have gone on strike complaining that their salaries - which equal trillions of Zimbabwean dollars - are not even enough to catch the bus to work each day...”

Are inflation ripples spreading?

Before the Zimbabwe dollar finally became worthless and had to be taken out of circulation in early 2009, inflation soared to nearly 500-billion percent according to the International Monetary Fund. It was triggered by a scarcity of foreign currency that caused shortages in just about everything from food to fuel. In April 2009, the Zimbabwe dollar was officially declared dead and completely worthless. Zimbabweans were forced to transact in gold.

Could this situation occur here? The possibility is remote according to the guardians of our financial system – experts such as Federal Reserve Chairman Ben Bernanke, a host of Federal Reserve Board members, Treasury Secretary Tim Geithner as well as a battalion of economists, bankers and professional money managers. In fact, they have warned us that deflation is the greater threat.

But not everyone agrees.

Here are samples of the contradictory media reports to which we’ve been exposed lately.

Fed’s Yellen Says Rates May Stay Near Zero for Years

Bloomberg News, July 1, 2009

“Federal Reserve Bank of San Francisco President Janet Yellen said the prospect that policy makers will leave the benchmark U.S. interest rate near zero for the next several years is “not outside the realm of possibility. We have a very serious recession, we have a 9.4 percent unemployment rate,” and inflation possibly falling further below the Fed’s preferred level, she told reporters [June 30] after a speech in San Francisco.

As for inflation, the “predominant risk” is that it will “be too low, not too high, over the next several years,” Yellen said. Inflation excluding food and energy may fall to about 1 percent over the next year and remain below 2 percent, with an unlikely possibility of turning into deflation if the economy fails to recover soon, she said.”

U.S. Inflation to Approach Zimbabwe Level, Faber Says

Bloomberg News, May 27, 2009

“The U.S. economy will enter “hyperinflation” approaching the levels in Zimbabwe because the Federal Reserve will be reluctant to raise interest rates, investor Marc Faber said. Prices may increase at rates “close to” Zimbabwe’s gains, Faber said in an interview with Bloomberg Television in Hong Kong. Zimbabwe’s inflation rate reached 231 million percent in July, the last annual rate published by the statistics office.

“I am 100 percent sure that the U.S. will go into hyperinflation,” Faber said. “The problem with government debt growing so much is that when the time will come and the Fed should increase interest rates, they will be very reluctant to do so and so inflation will start to accelerate.”

Federal Reserve Bank of Philadelphia President Charles Plosser said on May 21, inflation may rise to 2.5 percent in 2011. That exceeds the central bank officials’ long-run preferred range of 1.7 percent to 2 percent and contrasts with the concerns of some officials and economists that the economic slump may provoke a broad decline in prices.

“There are some concerns of a risk from inflation from all the liquidity injected into the banking system but it’s not an immediate threat right now given all the excess capacity in the U.S. economy,” said David Cohen, head of Asian economic forecasting at Action Economics in Singapore. “I have a little more confidence that the Fed has an exit strategy for draining all the liquidity at the appropriate time.””

Rising national debt raises prospects of eventual inflation

USA Today, June 28, 2009

 “Inflation is as dead as the Wicked Witch of the West in a waterfall. The consumer price index has actually fallen 1.3% in the past 12 months. So why is everyone so worried about soaring prices?

In a word: debt. The government owes the world $11.4 trillion — $37,000 for every person in the U.S. In the next fiscal year, the government will add $1.8 trillion to the deficit.

The government could simply print more dollars to pay off our debts with cheap currency — a tempting but inflationary solution. Politicians wouldn't have to ask citizens to pay for the government's services, and citizens wouldn't have to think about the actual cost of what they demand — until, of course, the currency collapses, interest rates soar and the economy craters.”

“If you're worried about inflation rearing its ugly head soon, relax. Inflation just isn't going to happen in this economy. “A lot of the worries about immediate inflation are examples of financial illiteracy," says David Wyss, chief economist for Standard & Poor's. “You won't get inflation until the economy gets back, and that's at least five years out.””

So who should we believe?

Getting real on inflation…

As the last article points out, the consumer price index has been dropping. In May the official consumer price index (CPI) registered its worst decline since 1950. But just how accurate is this modern-day CPI as an inflation meter? As Figure 1 shows, CPI has been substantially altered over the last 25 years.

Here is a comparison of the old and new consumer price indexes – the first (in red) is the alternate-CPI calculated pre-1982 before it was first changed during the Reagan Administration. The most recent alternate CPI showed an inflation rate of 6.15% in May.

This statistic is in sharp contrast the official CPI (blue line in Figure 1) published by the Bureau of Labor Statistics (BLS) which showed a 1.28% decline in May. That is a difference of 7.43 percentage points! Is it any wonder that the public is confused?

Figure 2 provides another perspective on the difference between the two CPIs and shows how the two estimates of CPI have diverged since the calculation was first changed in 1982. The left-hand scale shows the percentage difference between the official nominal CPI and the traditional calculation – a figure we’ll call the CPI fudge factor.

Figure 1 – Official CPI versus the SGS alternate CPI (calculated pre-1982) before the modifications by various government statisticians that comes to us courtesy of John Williams of www.ShadowStats.com . In May, the official CPI showed a 1.28% drop versus May 2008. This compares to a SGS CPI of 6.15% as it was calculated using the statistical methods pre-1982. Link: http://www.shadowstats.com/charts_republish#cpi

In the May report the BLS official CPI number was 213.86. The alternate-CPI was 636.48. Take the official CPI 213.86 and add 197.62% and you get the alternate of 636.48 (or nearly triple the official CPI)). As the chart also shows, the rate at which the two estimates are diverging is rapidly increasing as evidenced by the parabolic shape of the curve. It shows that government statisticians are increasingly “fudging” the CPI number to make inflation look more benign than it really is.  

Here is a point to ponder. Other than the price of a home and the cost of gas since July 2008 (which was a short-term spike), how much have your everyday costs of living dropped in the last year?  Or does an increase of 6% over the last year seem more realistic?

Paper Money Siren Song

The USA Today article above brings up an interesting point. With U.S. government debt levels climbing at such an alarming rate, wouldn’t the government be tempted to simply print its way out of the problem? And just how big is this bill? Perhaps more importantly, just how fast is it growing?

According to Williams of ShadowStats.com, U.S. government debt is at least three times greater than government debt in the rest of the world. As of December 2007, total U.S. government debt and obligations totaled more than $60 trillion and has grown significantly since then (Figure 3).

Figure 2 – Chart showing how much greater real CPI is than reported CPI. In May the Bureau of Labor Statistics reported an inflation rate of 213.86 which was 1.28% lower than the previous May. Real CPI as calculated before the changes after 1982 was 636.48 nearly 3 times (reported CPI plus 200% “fudge” factor).

 Figure 3 – Chart comparing U.S. government obligations and GDP with the rest of the world. The U.S. government had total obligations (debt) amounting to more than three times that of government in the rest of the world.       Source – www.ShadowStats.com

 If the government is printing dollars to help ease the debt problem, wouldn’t this show up in the Fed’s official money supply figures? What are the Federal Reserve’s money supply data telling us?  (For descriptions of the different money supply statistics published by the Federal Reserve please see Money Supply Definitions at the end of the article.)

Figure 4 – Chart showing M1, M2 and M3 money supply based on data from the Federal Reserve. Data for M3 after the Federal Reserve stopped publishing it in 2006 is provided by ShadowStats.com http://www.shadowstats.com/charts_republish#m3

 M1 (blue line in Figure 4), which is currency held outside of bank and government vaults and includes travelers checks and other checkable deposits rose more than 15% over the last year. M2, which is a larger measure of money supply and includes M1 plus savings deposits and shares in retail money market mutual funds grew at a slow rate of just under 10% per year. 

However, the growth rate of M3, which is a broader money supply measure and includes M2 plus large-denomination deposits; repurchase agreements, Eurodollar deposits, as well as institutional money market mutual funds, fell from above a growth rate of 16% in 2008 to around 7% in 2009.

No clear evidence of government printing presses working overtime so far.

However, one money supply metric – Adjusted Monetary Base (AMB) – has shown rapid growth in the last year. Defined as the sum of currency in circulation (outside Federal Reserve Banks and the U.S. Treasury, deposits of depository financial institutions at Federal Reserve Banks, and an adjustment for the effects of changes in statutory reserve requirements on the quantity of base money held by depositories), the annual AMB growth rate skyrocketed to more than 100% in January 2009 according to Federal Reserve data (see green line on Figure 5). Between June 2008 and June 2009, the AMB soared from $862 billion to $1.7 trillion.

However by definition, AMB does not include deposits in Federal Reserve Banks or the U.S. Treasury or deposits of financial institutions at Federal Reserve Banks so does not include the massive increase in Federal Reserve assets from around $800 billion last year to nearly $2 trillion this year. Which money supply measure includes those figures?

Figure 5 – Chart from the St Louis Federal Reserve showing changes in the adjusted monetary base. Why is this important? When Ben Bernanke talks about dropping money from helicopters to ease deflation risk, this is where it shows up.  (For more money supply definitions see http://research.stlouisfed.org/publications/mt/notes.pdf )

If the government did start printing money in ever larger amounts to pay off its debts, where would this show up in the statistics? And if these data were available could they be minimized and therefore be misleading due to the same sort of statistical manipulation that occurs with the CPI and other government-produced statistics? How can you protect yourself from the inflation wave that many believe is approaching?

Fiat Money Time-bomb?

Next month, we continue exploring the inflation/deflation question as we delve into the role fiat paper money has played. Fiat paper money is a currency that is not backed by a non-renewable precious commodity (such as gold, silver or platinum). Since 1971 when Richard Nixon took the U.S. off the gold standard, the U.S. dollar has met this definition – it is backed by nothing more than the faith and trust in the government to increase money supply in a responsible manner. Is this a realistic expectation?

Unfortunately, this duty has not stopped both Republican and Democratic administrations from spending beyond the ability of the nation to pay its bills. The result is growing budget deficits, a massive debt and an increasing reliance on foreigners to act as our nation’s lenders of last resort.

In his last year in power, Bush was responsible for a budget deficit north of $455 billion. But that is nothing compared to what his successor accomplished in his first 100 days. So far the projected budget deficit for fiscal 2009 tops $1.85 trillion or almost four times the 2008 deficit.

As a result, the U.S. has accumulated Federal government debt in excess of $11.4 trillion which works out to more than $37,300 per every man, woman and child in the country. This debt is projected to grow to more than $23 trillion by 2019. To keep paying the bills this year, the U.S. government will have to sell a total of $3.25 trillion of debt by September 30. Just the interest alone on the $11.4 trillion in debt at 3.5% (current interest rate on 10-year Treasury bond) amounts to an addition $400 billion per year!

But what is more troubling is the rate at which the federal government and Federal Reserve is spending money to address the current credit crisis – so far more than $12.8 trillion (and according to one estimate, more than $14 trillion) has been committed to by these two parties in the last two years. 

As investor Jim Rogers commented in June.

“This policy has never worked. The Americans tried it in the 90s. The policies which have worked let people who make mistakes collapse, let people who are competent take over the assets from the incompetent and start over. Now what’s happening is the government is taking the assets from the competent, giving the assets to the incompetent and saying now you compete with the competent. This is not going to work, its madness.”

Is he right? And either way, can we ever hope to repay this huge bill? What happens if we can’t? Could the government simply print its way out of this mess? No matter what happens, there are serious economic and financial implications to consider.

Stay tuned for the answers in part 2.

SUGGESTED READING

Hyperinflation in three parts with Ron Paul, Peter Schiff, Jim Rogers, Tom Woods, Marc Faber that is definitely worth a watch. 

1. http://www.youtube.com/watch?v=Yd0b5XIhCkM

2. http://www.youtube.com/watch?v=1O7jRfCqwSc

3. http://www.youtube.com/watch?v=vvc2GDgkAkQ

Dr. Chris Martenson explains the games government statisticians play http://www.chrismartenson.com/crashcourse/chapter-16-fuzzy-numbers

McCulley Says a New Stimulus Plan Must Show Restraint

http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aRhT2ANMiBlw

U.S. Debt Clock

http://www.usdebtclock.org/

Fiat Paper Currency: The History and Evolution of Our Money by Ralph Foster

http://home.pacbell.net/tfdf/