Kevin Feltes, an economist for the Jerome Levy Forecasting Center, solicited my opinion on a couple of their recent articles.



Levy comes down on the side of deflation, as do I. However, the devil is in the details, as always. I will go through one of their articles in a point-by-point fashion, stating where I agree and disagree with their analysis.



This is a long post. Please give it some time.



Please consider Widespread Fear of the Wrong Kind of Price Instability.



Levy:



It is not inflation but more disinflation and ultimately deflation that lie ahead in the 2010s.



Inflation worries remain a major part of the market backdrop, and the past year has brought new price stability concerns to investors. During that time, we have written about inflation fears, deflation risks, and the relationships between price trends and monetary policy, fiscal policy, Treasury debt levels, foreign debt holdings, and various other issues. We have argued that rising inflation will not be a threat in the coming years and that disinflation and some deflation are the real worries. Our position remains unchanged.



1. Why It Will Be Very Difficult for Inflation to Accelerate in the Next Few Years



The dominant influence on price trends in the near future and for years to come will be the deflationary influence of chronically high unemployment. The economy not only has gone through a deep recession but also has entered a contained depression, a long period of substandard economic performance, chronic financial problems, and generally high unemployment. The contained depression is likely to last about a decade; it will end in the latter half of the 2010s at the earliest and could stretch into the 2020s



In the years ahead, chronic high unemployment will weigh heavily on labor costs; chronic economic weakness will tend to keep profit margins under pressure and firms focused on cost control; and global instability and large areas of depression (contained or otherwise) will reduce upward pressures on prices of imported commodities and are likely to cause these prices to fall much of the time.



Even if imported commodity prices, most notably oil prices, rise sharply at times, they will not have a large, lasting effect on inflation as long as labor costs are decelerating or actually falling.



Labor costs are the dominant inflation influence not only because they are the single biggest component of prices, but also because labor costs are heavily affected by compensation rates, which fuel consumer spending and are therefore tied to the ability of firms to pass on inflationary price increases to consumers.



By contrast, oil prices, which are widely believed to be a critical inflation signal, have a weaker relationship to inflation over time, although they can be an important short-term influence. Labor cost inflation will remain subdued or even negative as long as unemployment remains high, and the prospects for a real recovery in labor markets are poor. A tightening labor market—a falling unemployment rate—would at some point trigger inflationary pay increases. Conversely, any unemployment rate that is substantially above such a trigger point indicates excessive competition for jobs and a tendency for pay raises to shrink—or pay cuts to become larger and more common. The trigger point, which varies from one business cycle to another depending on a variety of circumstances, is by any reasonable estimate far below the present figure of nearly 10%.

Mish Response

Missing the Boat on Labor-Induced Wage-Price Spirals

Labor cost inflation will remain subdued or even negative as long as unemployment remains high



Unemployment Rate 1960 to Present

CPI 1960 to Present

Annualized Wage Growth 1960 to Present

ability

ability

willingness

Greenspan vs. Bernanke

secular

Luck of the Draw

CS-CPI vs. CPI-U

click on chart for sharper image

Aftermath of the Credit Bubble Bust

Levy

2. Why Aggressive Monetary Policy Isn’t Causing and Won’t Cause Inflation



The notion of an inexorable link between monetary policy and inflation is pounded into our brains by the prevailing economic wisdom: “inflation is a monetary phenomenon,” “inflation is too many dollars chasing too few goods,” “central banks pump money into their economies to inflate their way out of trouble,” and so forth.



Yet creating more reserves in the system does not under all circumstances lead to additional demand, and if it does not, it cannot affect prices. True, under normal circumstances, easier money means lower interest rates, more credit creation, and more demand associated with that credit creation. But that’s not what happens when the economy faces what has been called the “liquidity trap,” when increasing the money supply does not induce more activity.



There are various theoretical reasons given for the liquidity trap, but let’s just focus on what is happening now and what is likely to happen in the years ahead. Presently, excess reserves are not inducing lending for several reasons, and adding to them further will not make much difference.



First of all, banks are capital constrained, not reserve constrained.

Second, interest rates could not fall far enough during this business cycle to enable troubled debtors to refinance their way out of trouble, so now banks remain worried about the volumes of bad debt they are carrying and how future loan losses will impinge on earnings and capital.



Third, deflationary expectations are beginning to work their way into banks’ loan evaluation process on a micro level; in more and more areas, loan officers are looking at households with shrinking incomes and firms with deflating revenues.

Fourth, the private sector has too much debt, and many households and firms are trying to reduce debt, especially as more of them worry about deflation in their own incomes or revenues.



Mish Response

in reality, lending precedes creation of reserves.

Lending Comes First, Reserves Second



Australian economist Steve Keen has made a strong case that lending comes first and reserves later in Roving Cavaliers of Credit. I discussed that at length in Fiat World Mathematical Model.



That point alone should seal the hash of the debate but it keeps coming up over and over. So let's try one more time.



Inquiring minds are reading BIS Working Papers No 292, Unconventional monetary policies: an appraisal.



Note: The above link is a lengthy and complex read, recommended only for those with a good understanding of monetary issues. It is not light reading.



The article addresses two fallacies



Proposition #1 : an expansion of bank reserves endows banks with additional resources to extend loans



Proposition #2 : There is something uniquely inflationary about bank reserves financing

....



What about the "Liquidity Trap"?

Ad Hoc Policy of Inflation

Contrary to Bullard's hypothesis that rising prices are desirable, we tend to think that most consumers would probably be quite happy to see falling prices. Note here that producers need not suffer either from a fall in prices. What is important for producer profits are relative prices. If their input costs fall to the same extent as their sales prices, they will continue to be profitable.



Bullard's error is the widely held belief that falling prices are synonymous with economic depression. We already mentioned in the past that this view can neither be supported theoretically nor empirically. The fastest period of real economic growth in US history of the past 150 years occurred before the Fed was founded, and coincided with steadily falling prices. Since Bullard does simply not say anywhere why he thinks the price level should always be rising, he seems to assume that this is self-evident. However, it is not. If falling prices were bad for an industry, the computer industry would not be an engine of economic growth, but would always be in depression. Until Bullard explains how such an 'exception to the rule' can not only exist, but actually thrive, we fail to follow his argument in favor of more inflation.



Levy

4. The Rapid Increase In Public Debt Is Not Likely to End in Disaster



Although public debt issuance is massive at present and will continue to be so, total debt issuance— public plus private—is much smaller than it has been in recent years, and it will remain depressed. Public debt growth may have accelerated to roughly $2 trillion annual rate, but net private debt issuance will likely be minimal or negative for many years as the private sector delevers; private debt growth had been running at about $4 trillion annual rate in recent years but has shifted into reverse, becoming negative (chart 4). Thus, although the federal debt is rising rapidly, the total debt level in the economy is not.

Mish

Response

click on chart for sharper image

True Money Supply

We Are In Deflation Here and Now

Inflation and Deflation Defined

Time to Short Treasuries?

Kass : Inflation is still an issue. Despite the Bureau of Labor Statistics' readings, inflation remains elevated and is not reflected in the current level of interest rates. The expected fiscal and monetary stimulation in the upcoming months will only serve to exacerbate inflationary pressures.



Mish : Before we can have a debate about whether or not inflation is a problem, we need to agree on what inflation is. Credit is being destroyed far faster than any monetary printing. Currently, Money Supply Trends Are Deflationary. In context of understanding what inflation is, treasury yields this low seem reasonable.



With rising unemployment will come still more foreclosures on both residential and commercial property. This will further impair bank balance sheets and any presumed recovery from this so called $150 billion "stimulus". It will likely take months, before that money gets into consumer hands and perhaps a year before Congress figures out it is meaningless.



Virtually no one, including Bernake thinks deflation can happen in the US. My position is that Things That "Can't" Happen are about to. The result will be Deflation American Style.



There is no bubble in treasuries if you look closely at the fundamental issues. Those who want to see how low treasury yields can get and stay there, need to look at Japan. Yields in the US are going to go far lower and stay lower longer than nearly everyone thinks.





Levy:

As revenues strengthen and social safety net spending eases, the deficit will tend to narrow rapidly on its own. As in the late 1940s and early 1950s, the debt-to-GDP ratio is likely to fall rapidly.

Mish:

The Model is Japan NOT 1940

Headed For Disaster

Levy:

8. Could the Economy Begin to Overheat When the Contained Depression Is Over, Leading to Rapidly Rising Inflation?



As long as the contained depression persists, and our best estimate is that it will last roughly a decade, the primary threat to price stability will remain deflation rather than inflation. Japan provides a graphic example of how an economy in contained depression — in Japan’s case, for nearly two decades — can run huge deficits, accumulate massive government debt, and still experience disinflation and deflation. The real inflation question concerns what will happen once the contained depression ends.



Although the future that far out holds many uncertainties, it appears that occasional spikes will be more likely than an ongoing upward wage-price spiral after many years of disinflation or deflation.

Mish:

Japan provides a graphic example of how an economy in contained depression can run huge deficits, accumulate massive government debt, and still experience disinflation and deflation

Conclusions

Why Aggressive Monetary Policy Isn’t Causing and Won’t Cause Inflation

Thanks