Saturday, September 1, 2012

Inflation or Deflation?

I have been thinking lately (go figure), and I have been trying to understand the whole inflation/deflation debate.  My question is below.   

Almost everywhere I look I see comments that all the money printing by the US Federal Reserve will lead to inflation.  Despite tripling their balance sheet inflation hasn't shown up at all.  The data actually points to slowing inflation. 

Are people making a flawed assumption that the money printing at the Fed will lead to inflation? 

That brings me to my second point, it appears that we are more likely headed toward deflation instead of inflation.  That seems at odds with conventional wisdom, but the Japanese experience of the 1990's comes to mind.  Add to this the fact that Fairfax Financial has some derivatives bets on deflation, they must feel deflation is a higher probability. 

What I find interesting is that people automatically link money printing to inflation, but is that a flawed assumption?  Don't get me wrong, I do believe it will have long term ramifications but in the short term we see some fairly astute investors (at Fairfax) betting the other way.  What gives?  Is the huge amount of debt in the system going to lead us toward deflation? 

Any Thoughts? 

I have some ideas on the subject but would like to see others think about this.  You can comment, anonymous comments will be allowed, or you can send me an email. 


Disclosure: Long FFH


  1. As I understand it, all the newly-minted money is being held on to by those who have first grab at it, i.e. those that sold short-term and long-term treasuries to the Fed. Inflation won't begin to show until all that new cash is spent and invested in the economy. Although, I don't have any actual data to back this up. Correct me if I'm wrong.

  2. Hi Kevin,

    I don't think these people to whom you refer are making a flawed assumption about the relationship between monetary inflation and price inflation. Necessarily, monetary inflation must decrease the purchasing power of the dollar given the laws of supply and demand.

    Where the flawed assumption occurs is in thinking the detrimental effects of monetary inflation, necessarily, will manifest in broad aggregates like the price level. This is not necessarily the case. Compensating factors may keep the price level relatively stable. For example, if an increase in the demand for money corresponds with injections of new money into the economy, a relatively stable price level may be observed.

    That said, the detrimental effects of monetary inflation will manifest elsewhere such as in relative prices (e.g., interest rates).

    So a related and equally important question on this subject is whether it is a flawed assumption to think a stable price level indicates monetary stability and economic stability.

    A book that has some helpful ideas on this topic is _Paper Money Collapse_ (Wiley, 2011) by Detlev Schlichter. Chapter 5 in particular, "Common Misconceptions Regarding the Price Level" is informative.



  3. Hi Joel,

    That is really an interesting comment.

    So the money printing at the FED isn't a big deal? Or is it?

    In trying to get my hands on that book I stumbled upon this comment from an Amazon review.

    “Really, no discernment between public and private debt. No discernment between the debt of currency users and currency issuers that owe their entire debt in the currency they issue. No discernment between Greece and other Euro nations that have turned their monetary sovereignty over to the ECB and nations like the US, UK, Japan and China that have not.

    Bank lending is constrained by reserves? Obviously, Schlicheter's never owned/operated a bank. A 200% increase in bank reserves since '08, bank lending has been constrained, and not a hint of generalized demand-push inflation (sure, cost-push oil and speculative gold). Cause and effect not working? Easy, let's just redefine the effect (inflation) as being our cause (increased reserves), and abracadabra, we can keep believing in the myth.”


  4. Kevin,

    The money injections by the Fed are a big deal. What's not a big deal are broad aggregates like price levels (e.g., CPI).

    These aggregates are very misleading about what's happening in the economy. Part of the reason for this is due to their inability to distinguish money-induced price changes from goods-induced changes in prices.

    As for the Amazon reviewer (I tracked down the review myself), it's a poor review. In fact, I don't think s/he has read the book. For example, contra their assertions, the book is not about hyper-inflation. It's a theoretical analysis of elastic monetary systems aimed at showing that they cannot achieve stability.



  5. I don't think we are anywhere close to seeing inflation. Until consumers diffidently deleverage, inflation is a dead issue.

  6. Brian Lee Crowley, an economist with the MacDonald-Laurier Institute here in Ottawa, had an interesting article in the Ottawa Citizen yesterday titled, "Why we should worry about inflation":



  7. Hi Kevin,
    This is a question that I wrestled with for a few years. In an open market price is simply set by what two parties agree upon, thus, psychology absolutely is a huge factor. When U.S. housing prices started collapsing it wasn't simply because the bank suddenly said that they will only lend the buyer x% of what they would have the day before, or that the number of buyers (demand) dropped by y%. As sentiment shifted so did the price parties agreed upon. In our society most markets are not truly free. Prices are set by vendors based on what the market will bear. Mark my words, when it is acceptable for Walmart to increase prices significantly every other retailer will do the same, regardless of what the(if any) the underlying reason is. My BComm and the CFA program were never that pragmatic. The study of inflation remains highly theoretical.
    Having said all that, if you go back and check the Fed's balance sheet expansion over the years there were other times of high growth (nothing like since 2008 though) it never coincided with inflation, but it did always lead it, and usually by quite a few years. It is my belief that the freshly printed money absolutely will cause inflation, but not until robust economic growth returns, and specifically, that capacity utilization rates are high. Just like in the 1970s. Remember, debt can bring consumption and capacity expansion forward. The U.S. is obviously suffering from the post-debt accumulation capacity hangover that will take years to soak up. Note: IMHO the ongoing government debt accumulation is not adding much to capacity or useful consumption. Anyway, Japan may be the best example in history of this and given its growth in all of the above in the 70s and 80s it is no wonder that their malaise has lasted so long.
    Back to the Fed. While the monetary base has grown by several trillion the money supply has stayed relatively stable because the multiplier effect has reduced (i.e. deleveraging). Banks are lending less and people are borrowing less. As Dr. Richard Koo has said, all of the economic textbooks in world say that if interest rates are zero, corporations should be borrowing like crazy to fund new projects, but if people are overleveraged they really don't care how low interest rates, and if corporations are running below capacity they won't hire more employees or build new factories. So the new money does not multiply, for now it is simply offsetting the deleveraging effect. I believe Bernanke understands this better than anyone and that he has actually done a great job given the mess he was handed. By the way, I have serious doubts whether the new money will ever be pulled out of the system (it never has been before), if Bernanke is still at the helm there is a chance, albeit very slim. So, I am certain that recent monetary action will cause inflation, but my guess is it is at least 6 to 10 years away. By then everyone will forget the root cause, except for me, you, your readers, Bernanke, and maybe Prem Watsa :-)
    Just my thoughts,

  8. Further to my prior post. As fresh money is put into the hands of the banks, it is largely sitting there, or even being re-deposited to the Central Bank. We saw that huge in Europe with LTRO II.
    New money, offset by deleveraging and a sluggish economy (i.e. a shrinking multiplier) = no inflation...for now.