Inflation or Deflation, why settle for just one?

If you are trying to decide whether to fret about inflation or deflation, don’t bother: you may just get both.

Yes, in the spirit of these austere times, it is a two for one offer; deflation comes first, followed by an almighty inflation after central banks press the “go nuclear” button on the quantitative easing machine.

It seems clear that, at least in the near term, the stars are aligned for deflation. Rather than lancing a massive debt bubble, policy-makers have added to it and the intense pressure to clean balance sheets has spread from corporations and households to nations.

As in 1937 in the U.S. or 1997 in Japan, a move to budget austerity has taken hold in large swaths of the global economy, adding to the intense downward pressure already being generated by very large unused economic capacity.

If neither banks nor governments are willing and able to stoke demand then prices will fall, and as we have seen, absent an outside shock this is a cycle which feeds on itself.

Consumers and businesses will pay down debts that are becoming heavier as money becomes more valuable and they will delay purchases as prices fall.

Of course in a system in which the government can create money at will, deflation should theoretically be an easy problem to solve; central banks can, in Chairman Bernanke’s famous image, simply drop money from helicopters.

That, of course, is a bit like saying that anyone can rid their house of termites, as long as they have enough gasoline and matches; it will work but there may be considerable collateral damage.

This difficulty of achieving a controlled burn, or printing just enough extra money to stop deflation but without unleashing very high inflation, is perhaps one of the reasons quantitative easing has such a chequered history. Unless you are in extremis, it is hard to commit to it wholeheartedly.

The U.S. rowed back from its efforts, at least in part because the Federal Reserve faced predictable political pressure from a policy of directing credit to the housing market, a move that usurped Congress’ check signing role and led to increased and unwelcome oversight of the central bank from the Fed’s viewpoint.

THE FIRE NEXT TIME

Adam Posen, a member of the Bank of England Monetary Policy Committee and an expert on Japan’s deflation experience, more or less nodded to the deflation first, then inflation theory in a speech on Wednesday, though he was quite confident in the banks’ ability to control the inflation genie once released.

Noting that inflation has remained above target in Britain and that inflationary expectations have risen, he concluded that this was in part the result of having had a very loose and very extreme monetary policy the face of quite dire threats.

Posen described Britain as being poised between “a recovery, which we are now in, albeit perhaps an initially weak one … and the renewal of a severe recession if not outright deflation”.

The creep of inflation expectations was then the “unsurprising result of having set monetary policy to prevent a terrible downside risk, and finding policy appears too loose if that risk thankfully does not come to pass.”
In short, the very real threat of deflation calls for policy that will, if successful, unhinge inflation expectations.

Of course, Britain is not the U.S., nor is it Japan, but even though the small island without a true reserve currency is being forced to take austerity steps that may call for extreme monetary measures, something similar could happen in the U.S. for slightly different reasons.

If political pressure for no new spending in the U.S. mounts, more quantitative easing by the Fed may be an achievable quick way to support the system.

The last time we had QE it was amid supportive fiscal policy and with a Europe that was not in a crisis of identity and form.

If European banks begin to fall, beyond the inevitable rescue it would be easy to foresee a coordinated and quite large programme of QE to fend off a generalized sovereign crisis.

This gets us back to inflation, but the question is where does it stop?

This is how we reconcile a world with U.S. 10-year bond yields below 3.0 percent and gold at $1244 per ounce. Many sensible people believe very much in the threat of deflation and a substantial minority think that contains within it the seeds of an inflation to come.