Inflation AND Deflation

From TPC:

We might as well buy some marble and hire a good engraver. The Fed and central banks around the world have all but written the epitaph of the next great boom bust period in global history. It will be a liquidity driven “recovery” that pales in comparison to the boom bust cycles we have previously created. The problem this time around is that it’s likely too boom in all the wrong places while the continued bust occurs across the entire consumer spectrum….

The Federal Reserve compounded the problems that the Bank of Japan created when they too added their own bit of carry to the market via the form of easy monetary policy. Of course, the results have been spectacular (in both good and bad ways). The added liquidity has created some of the greatest bull markets imaginable (not to mention a few memorable bears). Unfortunately, the men wielding the power of this liquidity were unaware of its potency and even less capable of containing it. I fear Ben Bernanke has opened Pandora’s box (or Greenspan’s box) one too many times and though the results have surely been miraculous in the near-term it is unlikely that this liquidity glut will end any differently than the last few. The major difference between this boom and past booms is that central banks around the world are mishandling the power of liquidity (as opposed to one or two).

Deutsche Bank elaborates on the potential outcome:

Will global excess liquidity continue to rise in the wake of expanding central bank balance sheets? Or will global excess liquidity be cut back due to softer lending?

The very recent re-acceleration of narrow money (M1) growth was driven primarily by rapidly expanding central bank balance sheets. This is particularly true of the US. Noticeably, US commercial banks are currently reported to hold deposits at the Fed worth almost 6% of US GDP, a steep increase from an average of 0.3% of GDP over the past two decades. These sizeable excess reserves by US commercial banks with the Federal Reserve suggest that the Fed’s extra-liquidity injections have not (yet) been transformed into new credit and hence money. Rather it has mostly stayed within the US banking sector for now, pointing to frictions in the credit creation process.

Although the central banks’ extra-liquidity injections are at the moment urgently needed to support the banking sector, the credit channel and hence the overall economy, they involve the risk that credit and money could surge at a future point in time to undesired high levels once the economies and hence lending stabilise again. Therefore, central banks need to pull the extra money out of the system when the credit multiplier process normalises eventually and before it starts running hot. Should the CBs exit strategies succeed, then the current extra-liquidity injections might overall be beneficial for the economy because they would support credit at times of financial turmoil without boosting credit and money to unsustainable, excessively high levels over the medium to long term.

Although central banks should be able to withdraw large parts of their (temporary) extra-liquidity programs by simply not rolling them over, the central banks’ commitment as well as timing remains crucial for success. Moreover, some nonstandard central bank measures (such as the Fed’s outright purchases of US Treasuries, agency debt as well as mortgag ebacked securities or the ECB’s outright purchases of covered bonds) might be more difficult to reverse quickly. Although central banks have a wide range of possible instruments to re-absorb today’s extra-liquidity injections whenever this becomes necessary at a later point, only the future will tell whether they started to act in a timely fashion. Given that central banks will try hard to avoid any further setback in economic activity, monetary policies could again turn out to be too accommodative for too long.

There are a number of different outcomes that could occur here. Scenario 1 would involve hyperinflation as central banks around the world fail to rein in excess liquidity. In this scenario precious metals, raw materials and stocks would all explode to the upside. The dollar would crumble, your savings accounts would get obliterated and bonds would deteriorate substantially. Think every gold bug’s dream.

Scenario two is the inverse and would be a deflationary environment where the massive debts built up over the past 20 years continue to crush U.S. consumers, capacity utilization remains low and de-leveraging continues for years. Think Japan redux. The dollar and bonds soar while most other assets crumble. I don’t see either scenario specifically occurring.

What I fear will occur here is scenario three: inflation and deflation. More specifically, inflation in the assets we need (think gasoline, consumer goods) and continued deflation in the assets we own (think housing and stocks). Many investors are arguing over the inflation versus deflation debate without recognizing that both can occur in various asset classes. While the liquidity glut is likely to cause inflation in commodities, the continued de-leveraging in the consumer sector is likely to cause deflation in many other assets.

Further compounding the problems at the central bank is the emergence of a U.S. dollar carry trade. Strategists at various firms have been recommending a carry trade using the U.S. dollar. Investors will effectively short dollars, purchase higher yielding currencies and use the proceeds to speculate on various assets - most likely inverse dollar plays such commodities. This could compound the Fed’s issues as they fight to reflate the assets we own. In essence, we would get inflation in the assets we need while high unemployment, stagnant wages and low capacity utilization keep a lid on the assets we own.

As Anna Schwartz said, the Fed is fighting the “last war”. The Fed has vowed to print our way out of this mess while allowing mistakes to go unpunished. The long-term bulls are dancing in the streets in recent weeks despite stock prices that are still 30% off their highs, 10% unemployment and housing prices that are 30% off their highs. Don’t lose sight of the forest for the trees here. This isn’t a sprint we’re experiencing, it is likely to be a marathon. They say history has a way of repeating itself and this movie looks like one I’ve seen one too many times before….The best thing that might result from all of this is that Ben and company actually are fighting the “last war”. Rather, the “last war” we allow them to so foolishly start….