Deflation Will Partially Negate Extreme Inflationary Policies

A: One can easily describe the environment today as one of extreme inflationary policies to combat deflationary forces and mass deleveraging from years of excess. That is how I like to look at it in terms of inflation or deflation. It gets more confusing when you start debating how one defines inflation. Some simply view inflation as a weakening of the relative currency. It is all relative right? If the US dollar is to get destroyed, it must do so against other stronger currencies. So really it is a question of which currency is the weakest at any given point in time. In other words, we can have extreme inflationary policies yet see a strengthening dollar relative to weaker major currencies. If anything, let us at least admit that a definition of inflation needs to take into account a few other dynamics. And in doing so, you will realize the bigger picture phenomenon at play right now...that deflation will partially negate extreme inflationary policies that are in place to support asset prices, a banking sector recapitalization, a smooth deleveraging process and economic stability that hopefully leads to a recovery.

Or you can say it this way --> extreme inflationary policies are in place to negate a deflationary spiral. I guess it boils down to how you define inflation. I tend to side with Mish that inflation is a expansion of the money supply and credit where credit is marked to market. While the money supply has surged as the fed responds to deflationary forces, the destruction of wealth in the shadow banking system is approaching $1.7 trillion or so. As a result, banks are contracting lending to consumers as credit quality deteriorates amidst a rising unemployment environment.

Take a look at the latest fed report on consumer credit and you will notice that there was a month to month decline of $21.5Bln (the largest monthly drop on record), and a fall of about $70Bln over the past year - non-revolving debt contracted at a 11.7% annual pace:

This trend is likely powered by a combination of consumers paying down debt balances and banks seeing rising charge-offs. Credit contraction of this magnitude is certainly not inflationary in a fiat universe with a fractional reserve banking system designed to have a money multiplier effect. Back to Mish:

"In a fiat world which we are clearly in, not much happens unless credit is extended or money somehow makes its way into the economy. Realistically "debt deflation" is about all one is ever going to see in a fiat regime. The reality is "Debt Deflation = Deflation" in a fiat regime. Indeed it is the destruction of debt that matters most.

Those who stick to a monetary definition of inflation pointing at M3, MZM, base money supply, or even Money AMS, are selecting a definition that makes absolutely no practical sense."

If it were not for deflationary forces and an extreme destruction in credit wealth, the US dollar would be much much weaker today - given that the extreme dollar negative inflationary policies were still put into place! Think about that for a moment. Deflation is playing a role in negating extreme inflationary policies and will continue to do so for probably a few more years. It's as if there is a currency battle going on between deflationary forces that should strengthen the dollar and extreme inflationary policies that aim to debase the dollar.

Now, lets get creative here. What if inflationary policies end up having some unintended deflationary side effects - the effect of higher rates, higher taxes, and higher commodity inflation come to mind and their combined effect on both consumers and corporations. I think that is part of endgame and will be the new reality once we get through this mess.

I really think that any inflation we see first will be of the 'crunching' variety right as unemployment reaches its peak across this country. That is, I think inflation will first show up in the form of higher energy prices, higher food prices, higher health care costs, higher rates, higher taxes, higher commodity prices, etc..the stuff that we need to live on day to day. Those expecting wages to rise and housing to surge as a side effect of inflation will likely be disappointed due to the credit shock we have been through and the residual damage that was done to the banks balance sheets, the securitization model, the consumer balance sheet, elimination of exotic loan products, tighter lending standards and the speculative/move-up/move-across home buyer.

It gets confusing when you start talking about how inflation will support housing prices, especially those hyperinflationists that see housing price levels surging to peak levels as a result of the weakening dollar. I disagree with this 'inflation induced home price surge' for a number of reasons but I do not discount the possibility that we will see natural rebounds off the trough from the hardest hit markets! After fierce destruction, one would expect a bit of a rebound as past housing reports including high amounts of distressed sales are ultimately compared to.

Housing is tied to the availability and cost of credit in addition to fundamentals like a strong labor market, rising wages, and simple supply/demand imbalances. Add in a host of other dynamics like securitization of loans, easy appraisals, exotic loans allowing affordability to surge, no underwriting standards, govt subsidized lending rates, first time buyer tax credits, housing programs and a speculative bubble component and you have the makings of an asset class that is festered with outside interference. Its not just about the house being priced in US dollars. Rather it is a amalgam of forces that can affect which direction housing prices drift. Sure the dollar may weaken, but in no way will the engine that powered housing growth over the past decade work like it did as we approached the peak in credit.

Therefore saying a weaker dollar IS inflation and in times of inflation housing SHOULD rise because the asset is priced in dollars, will have some flaws to it because the recipe for housing success has greatly changed in today's world.

With deflation the US dollar should swell. This is what happened during the course of 2008 which since has been negated some by inflationary policies and a rush out of dollars to higher yielding asset classes; doesn't mean we have an inflation problem now though. The net move in the US dollar was muted because of deflationary forces and the rise that our currency saw when the crisis reached its zenith.

Already we are hearing talk of possible exit strategies by our fed to limit any whiplash inflation resulting from the extreme policies put into place to stem this crisis. The most recent is the potential for tighter capital requirements for our banks - Greenspan on Bloomberg:

Former Federal Reserve Chairman Alan Greenspan said banks should be forced to hold more capital on their balance sheets, reinforcing a weekend push by finance chiefs from the Group of 20 nations.

I listed this as #4 in exit strategies to expect in 2010 & 2011, as the fed reins in emergency lending facilities. The process of writing off bad loans/securities and debt-restructuring will continue until consumers and businesses can sustainably maintain debt service payments. When the debts are written down to where they should be, we can start to discuss future sustainable credit growth. Until this process plays out the fed is likely to maintain stimulative inflationary policies. In the end, banks need sound consumers & businesses to lend to and that is the deflationary process that is ongoing today.

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