Tuesday, July 14, 2009

What'll it be? Inflation or deflation? Or both?

Lost in the fear of inflation that has gripped many for months, is the reverse and almost silent bull market killer, deflation. In recent days however we have seen that deflation has again made the news.

In Japan it was reported that "
."..wholesale prices fell a record 6.6 percent in the year to June, as the world's No.2 economy slides deeper into deflation",
In Ireland, the TimesOnline reports that
"Ireland sunk further into deflation in June as the cost of living fell at the fastest rate since the Great Depression, raising the prospect of a prolonged recession"it is deflation that is the problem.
The prospect of deflation has even hit the pages of the US's WSJ Wall Street Journal:"
... falling commodity prices swept away lingering fears of inflation and fueled fresh economic concerns....Contracts on the 30-year bond saw bigger price gains, closing nearly two full points higher with yields seen below 4.25% at contract expiration. "The participants looked around and saw deflation everywhere," said James Barrett, a market strategist ...who cited falling prices in grains and metals alongside energy Wednesday

Most of us know the traditional (and well documented) truth that higher money supply growth leads to inflation rule. How can their be deflation with such a growth in the money supply?

There is no simple answer but when you couple the fact that banks are not making as many loans as they did previously and consumers are not buying as much as they did previously, you have at least the right conditions for deflation.

To make matters worse, the money being spend under the Fed stimulus packages may not be having as large of impact as had been hoped/expected. For instance consider the following article that Charlie a former student of mine sent:

Debt and Deflation - John Mauldin's Outside the Box - InvestorsInsight.com | Financial Intelligence, Advice & Research / Investment Strategies & Planning for Individual Investors.:
"...week, the most important question that an investor can ask is whether we are in for deflation or inflation. And this week we read a well reasoned piece on deflation. ...Van Hoisington and Dr. Lacy Hunt give us a few thoughts on why they think it is deflation that will ultimately be the problem and not inflation we are dealing with today....

...Barro and Perotti are saying that each $1 increase in government spending reduces private spending by about $1, with no net benefit to GDP. All that is left is a higher level of government debt creating slower economic growth."

"....a paper written at the University of California Berkeley entitled The Macroeconomic Effects of Tax Changes: Estimates Based on a new Measure of Fiscal Shocks, by Christina D. and David H. Romer (March 2007). (Christina Romer now chairs the president's Council of Economic Advisors). This study found that the tax multiplier is 3, meaning that each dollar rise in taxes will reduce private spending by $3."

So what do you think? Inflation? Or Deflation.

This is the new poll question I included on the blog: which is more likely Inflation or Deflation?" It's off on the left. Right now Inflation is ahead 58% to 42%.

And if you are not confused enough, one scenario worth considering is short term deflation (due to lower demand), and then longer term inflation (due to higher money supply growth) when the Fed has a difficult time withdrawing money from the system.

Thanks Charlie!

1 comment:

ATS said...

Hi Finance Professor,

I just have a quick question, and would love to hear your comments on this. You ask: “How can their be deflation with such a growth in the money supply?”

Isn’t it credit supply and not money supply the primary cause of inflation? So, despite an increase in money supply, if it really isn’t being lent out, wouldn’t inflation be kept at bay? Stiglitz, in “Towards a New Paradigm in Monetary Economics”, seems to make the point that credit is what matters and not money. Moreover, he argues that credit is fundamentally different from money in that credit supply also requires information about and trust for the person to whom you lend. Stiglitz also points out that traditional monetary economics was based on a transaction model of money and not one based on credit and information asymmetries.

My questions: Is Stiglitz correct in pointing to credit as the foundation for monetary economics and not transactions or money supply? Would that explain why we currently have deflation despite an increase in money supply?

Sincere regards,
Long-time reader