Wednesday, June 22, 2011

Deflation is Dead, Long Live Deflation

Today was the Federal Reserve's scheduled meeting to set interest rate policy.  The meeting itself was largely a non-event i.e. interest rates will remain at 0% indefinitely - same as the past 2 years.  With respect to Quantitative Easing aka. printing new money without an exit strategy, the Fed stood firm on winding down QE2 at the end of this June.  Bear in mind that all of the assets that the Fed purchased during QE1 and QE2 will remain on the Fed's Balance sheet indefinitely (forever).

Much more important was the Wizard-of-Bernank's Press Release following the formal meeting, during which he stated that "we no longer have a deflation risk" (i.e. thanks to QE2).  

There you have it, the ultimate capitulation - the Fed is giving in to the Tea Party Inflationist Gold Bugs who are convinced that hyperinflation is imminent.   This is a political capitulation, because from an economic standpoint, by its own admission, the Fed has no clue when or if the weakening economy will recover and also admits that the Housing sector is in renewed decline !  How do they then reconcile these two view points, that the economy and key sector is weakening and yet that deflation has been averted ?  It's logically impossible to maintain these two beliefs simultaneously.  More importantly, in stating this position, the Fed is saying "Mission Accomplished" and hence ensuring that the extraordinary measures taken to avert deflation (QE1 and QE2) will not be repeated.  This is a major nail in the coffin for the economy, for housing and for the risk markets.

Unfortunately, not withstanding the Great Wizard, the three generations since the Great Depression have forgotten the risks of too much debt and the inevitable deflationary consequences.   There is absolutely no exit strategy for a debt laden economy in which total debt has reached a multiple of GDP, as it has for most of the Western nations (U.S., Canada, Europe, Japan etc.), other than via liquidation, bankruptcy, foreclosure and default.  All of our accumulated debt represents years of inflated consumption and hence inflated GDP giving us all a sense of financial well being that is totally unsustainable.  And of course, beyond Peak Credit at the point of recognition, the economy will revert back to its sustainable level which will be many percentage points lower than it was at the apex of spending and debt accumulation.  Adding in the devastating effects of outsourcing and the liquidation of locally owned businesses, and any transition strategy becomes even more unattainable.

Up until now, all Central Bank machinations - interest rate manipulations, various lending programs, asset-buying programs etc. have had one goal which was to save the credit markets and prevent lenders from pulling back from the markets.  However, the global credit market is roughly $50 trillion in magnitude and therefore well beyond the scope of any Central Bank to manipulate indefinitely.

In the age of "Wrong is Right and Right is Wrong", therefore, we need to invert the Wizard-of-Bernank's statement to understand its true meaning, that deflation has not been averted, and is in fact already underway.