Why it’s Deflation…Not Inflation, that’s Heading Our Way


I don’t think the Fed can get interest rates up very much, because the economy is weak, inflation rates are low. If we were to tighten policy, the economy would tank. Ben Bernanke’s response to a question from the House Financial Services Committee hearing held on Wednesday 17 July 2013

After increasing the money supply at a rate of 33% per year for the past five years, the best US Federal Reserve chairman, Dr Ben Bernanke can manage to achieve is ‘the economy is weak.

The sheer volume of newly minted dollars has financial experts and gold bugs searching the horizon for evidence of inflation and even hyperinflation. The theory is, ‘Surely with this much money being added to the system, higher inflation must soon appear on the horizon?’

Conventional wisdom suggests inflation should be a by-product of the central bankers’ efforts with the printing press.

However, the fact is we aren’t in conventional times. Therefore the world as we know (or think we know) it may not act in its usual ‘Pavlovian’ way.

The following chart on UK inflation rates dating back to 1265 shows persistent inflation is only a 20th century phenomena.

Prior to 1900, the UK and other developed economies experienced the ebb and flow that happens when humans interact in a buying and selling process.

Supply, demand, greed, fear and a host of other variables drive our decision-making process. This in turn moves the economy in certain directions – positively and negatively.



Source: Credit Suisse

The negative period in the early 1900’s was a result of ‘The Panic of 1907’. This severe downturn gave the authorities and big banking interests an excuse to set up a central bank.

Lesson number one for the rich and powerful is ‘never let a good disaster go to waste’. They sold the central bank concept to the public as a tool to stabilise the economy.

Ever since then, central bankers have ‘controlled’ the economy. But the value of a dollar has been anything but stable. Inflation has all but vaporised the buying power of a dollar issued a century ago.

Due to central bank meddling intervention, inflation is all we have known for the past century. Little wonder we expect inflation – especially when the Fed now prints more money in a year than it did for the previous century.

Yet in spite of all we think we know about the economy, ‘inflation rates are low.‘ The following graph confirms Bernanke’s testimony.

The core personal consumption expenditures deflator (an indicator the US Fed watches closely) is at a fifty year low with just a 1% year-over-year change.

Bernanke is fervently following the manual written by those who went before him. However, it’s not producing the outcomes they achieved.

A hundred years is a long time for an experiment (and that’s what central banking is) to show consistent and reasonably predictable results. However, they can only repeat the results if the lab conditions are the same each and every time.

And that’s the subtle but key missing piece of the puzzle that most people have overlooked – the lab conditions aren’t the same.

  • World population quadrupled in the past century – finite resources mean this is unlikely to happen in the next century.
  • Population growth in the western world has stabilised compared to the growth rates of the past century.
  • Household balance sheets are dripping in red ink – capacity for more personal debt is declining.
  • Compared to a century ago, government welfare, healthcare and warfare obligations are ‘through the roof’. A sustained period of consumption (producing higher tax revenues) won’t rescue heavily indebted and over-obligated governments this time.

For the time-being the days of excess consumption are in the past.

The following chart (dating back to 1965) shows over the past five years there has been a 90% correlation between what consumers earn and what they spend.

Compare this to the 2002 to 2007 period (the credit bubble period) when there was next to no correlation between earnings and expenditure.

Why was that? This was when consumers treated their home as an ATM – using home equity loans to fund consumption.

The next chart on Mortgage Equity Withdrawals (MEW) shows the debt feeding frenzy that occurred from 2002-2007. Since the GFC hit it has been all downhill. The consumer focus has been on living within their means and repaying (or, defaulting on) debt.

Inflation is the by-product of money creation plus credit.

In the past five years the Fed has produced around US$2.5 trillion of new money. Over the same time, the private sector has cut debt levels by US$4 trillion.

There are a couple of other telltale signs of inflation that are pointing in the wrong direction. Commodities prices have trended down for the past two years, and the Baltic Dry Index (an indicator of global shipping activity) is down to levels last seen during the GFC.

The Great Credit Contraction is producing the equal and opposite effect of The Great Credit Expansion. The inner tube of the global economy has a puncture – more air is escaping then the central bankers can pump in.

When a tyre loses pressure it is DEFLATING.

But the deflationary outlook isn’t unique to the US. Look at this chart from a recent Societe Generale report:

Here is an edited version of the commentary accompanying the chart (emphasis mine):

Perhaps, though, the most decisive macro factor for all markets will be any slide into deflation in China…. The recent Q2 GDP data contains the surprising fact that China’s implicit GDP deflator had slowed to only 0.5% yoy – noticeably weaker than the CPI data… The fact that China is on the verge of outright deflation may prove more important than even Fed tapering.

But don’t worry. Bernanke has it all under ‘control’ – after all isn’t that what central bankers believe?

How’s this for supreme confidence. When asked how the Fed will exit its QE (quick & easy) money experiment he said:

We know how to exit. We know how to do it without inflation… We have all the tools we need to exit without any concern about inflation.

The only tools Ben has at his disposal are the other board members sitting around the Fed’s boardroom table.

Four years of money printing have done nothing but damage the integrity of markets. By distorting interest rates they have forced investors into high risk investments paying low returns. Let’s face it, for the average punter a few percent from anything looks a whole lot better than 0.25% in the bank.

The longer this experiment is allowed to continue (and Fed hubris means it will be for longer than anyone expects), the greater the dislocation in markets. When GFC Mk II hits, consumers will retreat even further into the cave of cautious spending and debt reduction or default.

The irony is the Fed’s money printing has increased the odds of a deflationary outcome.

A century of central bank meddling in markets has produced another type of inflation – in the form of central banker egos and belief in their abilities.

The pending market upheaval will hopefully deflate these puffed up theorists.

Vern Gowdie
Editor, Gowdie Family Wealth

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From the Archives…

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Asteroid Mining and the Commercialisation of Space
16-07-2013 – Sam Volkering

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Vern is a contributing editor to Money Morning — Australia’s biggest circulation daily financial email. (To have Money Morning delivered straight to your inbox you can subscribe for free here). Vern has been involved in financial planning since 1986. In 1999, Personal Investor magazine ranked Vern as one of Australia's Top 50 financial planners. His previous firm, Gowdie Financial Planning, was recognized in 2004, 2005, 2006 & 2007, by Independent Financial Adviser (IFA) magazine as one of the top 5 financial planning firms in Australia. Vern has been writing his 'Big Picture' column for regional newspapers since 2005 and has been a commentator on financial matters for Prime Radio talkback. His contrarian views often place him at odds with the financial planning profession. In his leisure time Vern remains active with triathlons and pilates. Official websites and financial eletters Vern writes for:


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