Guest Post: The Fed's Real Worry – A Pick Up In Deflation

Submitted by Lance Roberts of Street Talk Live blog,

In several of my recent missives I have made several references to the wave of deflationary pressures that are currently encircling the globe.  

In “Japan: A Few Thoughts On The Crash” I stated:

“The unintended consequence of such actions, as we are witnessing in the U.S. currently, is the ongoing battle with deflationary pressures. The lower interest rates goes the less economic return that can be generated. An ultra-low interest rate environment, contrary to mainstream thought, has a negative impact on making productive investments and risk begins to outweigh the potential return.”

Also, in “Bernanke’s Link to “Mother Nature”

“How many more natural disasters will come to offset the negative economic impact of a zero interest rate environment coupled with a wave of deflationary pressures is unknown.

But most importantly in “Why Bonds Aren’t Dead & The Dollar Will Get Weaker” I stated:

A wave of ‘disinflation’ is currently engulfing the globe as the Eurozone economy slips back into recession, China is slowing down and the U.S. is grinding into much slower rates of growth. Even Japan, despite their best efforts through a massive QE program, cannot seem to break the back of the deflationary pressures on their economy. This is a problem that has yet to be recognized by the financial markets.


The recent inflation reports (both the Producer and Consumer Price Indexes) show deflationary forces at work. Wages continue to wane, economic production is stalling and price pressures are falling. More importantly, there are downward pressures on the most economically sensitive commodities such as oil, copper and lumber all indicating weaker levels of economic output. The battle against deflationary economic pressures has been what the Federal Reserve has been forced to fight since the financial crisis. The problem has been that, much like ‘Humpty-Dumpty’, the broken financial transmission system, as represented by the velocity of money, can’t be put back together again.”

The last paragraph above is particularly important.  The biggest fear of the Federal Reserve has been the deflationary pressures that have continued to depress the domestic economy.  Despite the trillions of dollars of interventions by the Federal Reserve the only real accomplishment has been keeping the economy from slipping back into an outright recession.  However, when looking at many of the economic and confidence indicators, there are many that are still at levels normally associated with previous recessionary lows.  Despite many claims to the contrary the global economy is far from healed which explains the need for ongoing global central bank interventions.  However, even these interventions seem to be having a diminished rate of return in spurring real economic activity despite the inflation of asset prices.

Despite the ongoing rhetoric of those fearing inflation due to the Fed’s monetary interventions the reality is that such actions have, so far, failed to overcome the deflationary forces of weak global demand.   The chart below is the spot price of copper.   Copper, often dubbed “Dr. Copper”, is very sensitive to economic growth as copper is used in everything from production, to manufacturing, transportation, housing, etc.   So goes copper – so goes the economy.   Copper is currently confirming the peak in economic growth for the current cycle.

However, the question remains, do we have inflation or don’t we?  Are we experiencing the 1970’s all over again as inflation kills the economy, or in the words of Ben Bernanke, have we entered an era of low inflation and interest rates that will last for some time as the threat of deflation remains a prevalent enemy to the economic recovery?  

3 Components Of Inflation

I believe that there are three components required to create a truly inflation environment. 

Commodity price inflation is certainly one of them as it does immediately impact the consumptive capability of the average consumer.   However, in order to see true pricing pressures across the economy there are two other factors that are critical; 1)the velocity of money, or how fast money is flowing through the system from the banks to small businesses and ultimately consumers, and; 2) wage growth which gives the consumer increased purchasing power.

Why are these two factors so critical to overall inflation question?   In the most recent  NFIB survey only a small fraction of respondents stated that this was a “good time to expand their business” while the majority of respondents stated that their major concerns were “poor sales, taxes and government regulations”.  If you are a small business, who coincidently creates roughly 70% of all new jobs in the economy, and you are worried about poor sales prospects and a weak economic environment, it is highly unlikely that you are going to borrow money to expand your business or extend credit to customers.  Businesses in turn choose to hoard cash as a hedge against a weak economic environment instead of making productive investments that will lead to more jobs and higher wages. 

Besides the rise and fall of commodity prices, which do indeed contribute to the inflationary backdrop, the demand for money to make productive investments by businesses which leads to higher levels of production, wage growth and, ultimately, consumption is what drives overall inflation.  It is important to remember that in economics inflation is:

“…a rise in the general level of prices of goods and services in an economy over a period of time.  When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation reflects a reduction in the purchasing power per unit of money – a loss of real value in the medium of exchange and unit of account within the economy.”

It is very difficult to have a “general rise in price levels” amidst a lack of consumer demand driven by suppressed wages, high levels of unemployment and little demand for credit by businesses. The lack of demand exerts downward pressures on the pricing of goods and services keeping businesses on the defensive.  This virtual spiral is why deflationary environments are so dangerous and very difficult to break.

I have constructed a composite “High Inflation Index” in an attempt to measure these three legs of inflationary pressures.  The purpose, of course, is to visualize the data to determine if inflation is prevalent in the current economic cycle or not.   The index is equally weighted of the M2 Velocity of Money, the Year Over Year (YOY) percent change in wages and the YOY percent change in the Consumer Price Index (CPI).  The first chart shows the historical levels of each of the three components.

Notice that there is a very tight relationship between the rise and fall of compensation of employees and the velocity of M2 money supply.  With M2 velocity plunging to historically low levels this does not bode well for sustained increases in either employment or compensation as the demand for money simply does not exist currently.  The next chart is the weighted average of the three components into an index. 


The index clearly shows the “high inflationary” pressures that were prevalent in the 1970’s as the economy suffered real inflation and rapidly rising interest rates.   Recently, inflationary pressures rose as economic growth surged from the lows of the financial crisis as the economic system was flooded by trillions of dollars of stimulus, bailouts and financial supports.  However, that surge, in both the economic growth and the inflationary pressures, peaked in early 2011 and have been on the decline since.  This is why the Federal Reserve remains extremely worried about the diminishing rate of return on their monetary experiments as it relates to the economy.  Inflating asset prices higher have increased consumer confidence but has had little translation into the creation of underlying economic growth.

With the index clearly warning of rising deflationary pressures in the economy, which has recently been seen in many of the manufacturing reports that have shown downward pricing pressures both on prices paid and received, there is no “exit” currently for the Federal Reserve to reduce its monetary supports.  The real concern is that with the index at just 4.88%, which is well below the long term average of 11.63%, that the economy is far to weak to handle much of an exogenous shock.

The risk, as discussed recently with relation to Japan, is that the Fed is now caught within a “liquidity trap.”  The Fed cannot effectively withdraw from monetary interventions and raise interest rates to more productive levels without pushing the economy back into a recession.  The overriding deflationary drag on the economy is forcing the Federal Reserve to remain ultra-accommodative to support the current level of economic activity.  What is interesting is that mainstream economists and analysts keep predicting stronger levels of economic growth while all economic indications are indicating just the opposite.

Despite the Fed’s recent communications that they are planning to “taper” the current monetary program by the end of this year – the index is suggesting that their interventions, in one form or another, are unlikely to end anytime soon.  The threat of “deflation” remains the Fed’s primary concern.


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