First the Deflation then the Inflation: Is this the start of the Deflation?

At the start of the year in my ‘Predictions for 2011’ I wrote: “If I had to guess, I’d say that we are likely to experience a decent first half of the year, followed by a serious correction, probably affecting all risk assets, and possibly a decent rally to finish the year as central banks coordinate to stimulate once again.” It now looks like this is starting to play out.

Since the start of May the FTSE 100 is down over 6% and the Dow Jones is down more than 7% and markets across the world are following a similar pattern. The MSCI All Country World Index, which is designed to measure the equity market performance of developed and emerging markets and consists of 45 country indices, is also down more than 7.5%. With all the headwinds facing the equity markets, including: the sovereign debt crisis, record inflation, property bubbles on the brink of bursting, high oil prices, the crisis in Japan and record food prices, it’s amazing it’s taken this long for markets to start pricing in an economic slowdown.

First the deflation

In my view this is the beginning of the deflationary episode. How bad it gets, i.e. how long the selloff lasts, and how low stocks and other risk assets go, will depend on how long the Fed and other central bankers wait to respond. But respond they will, believe me, nothing scares central bankers more than deflation.

Deflation is defined as a fall in the supply of money, something that makes cash more valuable and has the effect of making goods and services cheaper. When confronted with falling prices businesses and consumers delay spending and consequently money velocity slows and so too does economic activity.

Deflation also handicaps governments by making it impossible for conventional monetary policy to deliver negative real interest rates – a key weapon in their fight against recession. The faster the deflation, the higher real interest rates will be. This is good news for savers but crippling for debtors. As explained by the great American economist Irving Fisher in the 1930s, “debt deflation” – the rising real value of debt as prices fall – is a serious threat to anyone with debts, and by far the biggest debtors are governments themselves. Official UK debt is now at £2.3 trillion ($3.74 trillion), while US debt is around £8.8 trillion ($14.294 trillion).

 

Then the inflation

My guess is the Fed will respond first. Once the pain gets bad enough Obama will want Bernanke to do something. He is up for re-election next year and uppermost in his mind will be an unemployment rate of 9.1% – it’s actually 15.8% when you include those who have given up looking for work and those forced to work reduced hours.

I’m confident that Ben Bernanke still has plenty of tools at his disposal. During his infamous speech in 2002, before he became Fed Chairman, Bernanke said: “The U.S. government has a technology called a printing press (or today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at no cost.” He later went on to make his famous statement about using “helicopter drops” to put money into the economy to fight deflation. This is how he got the nickname “Helicopter Ben”.

We can therefore expect more money printing from the Fed, though I don’t imagine they will call it “QE3” given that QE’s 1 and 2 failed to deliver. They might even resort to mailing cheques to people as they did during the credit crisis. I also wouldn’t rule out a coordinated response from all of the G7.

Don’t get me wrong, it’s not what they should do. Government has no place propping up markets and bailing out troubled businesses, they should just get out of the way and let the market determine the rightful value of stocks, property, interest rates etc. Recessions are a natural part of the business cycle and these neo-Keynesians should stop trying to prevent it taking place. The malinvestment needs to be cleansed from the system and each time our policymakers attempt to stop it they serve only to create more misallocations of capital. It’s a situation that’s unsustainable and the longer we postpone the day of reckoning the worse that day will be when it finally arrives.

Buying opportunity

This deflationary episode will likely present a decent opportunity to buy some distressed assets and I hope to use it to pick up some of the companies on my shopping list.

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