can a dollar crisis be deflationary?

[jk]

the conventional wisdom from u.s.a. today, quoted by richard russell, is:
"Once foreign investors lose confidence in the dollar, the consequences can be dire. They are, after all, financing a big chunk of the US debt. Foreigners are big buyers of US Treasuries at auction. They own nearly half of all publicly traded US debt and 25% of US corporate debt and mortgage-backed debt. If foreign buyers lose interest in US debt, the Treasury will have to offer higher interest rates to attract buyers. The dollar could fall further, import prices would rise, inflation would surge. Higher rates, in turn would slow the economy."

the reasoning implicit in the predicted series of events runs: lower dollar=> rising import prices and rising rates=> inflation "surges" while the economy slows, i.e. stagflation.

i'd like to focus on the "inflation surges" part. yes, import prices would rise to the extent that the exporters don't absorb the hit, as many of them would try to do to maintain their export industries. but even so, are imports that big a component in the inflation figures? if the dollar drops i suppose oil would rise further and eventually higher energy prices would feed through. but that would take a significant amount of time.

in the meanwhile the higher rates would act immediately to kill housing instantly and altogether, and if the fed defends the buck by raising the discount rate all those floating rate home equity loans would start strangling the finances of even relatively reasonable households [let alone the leveraged-to-the-gills household on the margin]. this seems a recipe for deflation.

to summarize- in a dollar crisis, if the fed defends the buck the interest rate effects are quick, the inflationary effects slow. this produces DEflation.

so, on the other hand, suppose the fed doesn't defend the currency. rates stay low at least on the short end of the curve. if long rates rise too much ben fires up the helicopter for "unusual measures" i.e. buying long-dated bonds to control the WHOLE yield curve instead of just the short end.

that scenario is inflationary, but could take a long while to play out.

am i missing something?

[blazespinnaker]

I think it depends on how you define inflation / deflation.

If you look at housing prices, then yes, deflation could occur.

If you look at rental rates (which I think is what the fed does), I think inflation could skyrocket as people can no longer buy houses and start renting while the bubble bursts.

[jk]

definitions

you're right that we have a definitional problem. people are now saying that inflation isn't really so bad because it's distorted upwards by using owner's equivalent rent, which is increased when higher rates price people out of purchasing a house. i have noticed, however, that these people didn't complain that the inflation rate was distorted down by the same mechanism when rates were going down.

if we mean by inflation "that which is measured by the [core?] cpi," then you're right. higher rates will show up as higher owner's equivalent rent.

what i'm wondering is whether a dollar crisis can cause a deflationary crisis, a collapse of prices for all assets as people try to get liquid?

[blazespinnaker]

what i'm wondering is whether a dollar crisis can cause a deflationary crisis, a collapse of prices for all assets as people try to get liquid?

I hope so

Seriously, though, this is where I've made my big bet.

Will it happen? And soon, preferably?

I don't know. I'm watching energy / the environment. If energy prices drop hard, I could be seriously screwed as the economy takes off.

[jk]

I hope so

Seriously, though, this is where I've made my big bet.

Will it happen? And soon, preferably?

I don't know. I'm watching energy / the environment. If energy prices drop hard, I could be seriously screwed as the economy takes off.

i think the only thing that will drop energy prices hard is a global slowdown/recession/depression/deflation! it's interesting to notice that we can start with the same premises and end up with opposite scenarios.

i think it has something to do with which process leads and which follows.

you start with the hypothesis that energy drops and look at how great that would be for the world economy. i suppose that would be true if the price dropped because of huge new discoveries of oil, or discovery of efficient and cheap alternative energy processes. then, yes, the price of energy would drop and other assets would benefit.

however, i start with energy dropping and look backwards: what might have happened to make energy drop? [here in this world, without wonderful new discoveries]. all i can come up with is the very deflation you say you want but think low energy prices would prevent.

[blazespinnaker]

No I'm completely with you here. I too am looking for commodities to drop because of economic slow down. I'm all over that!

My fear is some big leaps forward in alternative fuel / discoveries / etc. Damn scientists!

Fortunately, my downside has a lot of general global upside. The idea that if I suffer everyone (including me) will gain, isn't such a bad thought.

[Jim Nickerson]

Definition of inflation/deflation.

you're right that we have a definitional problem. people are now saying that inflation isn't really so bad because it's distorted upwards by using owner's equivalent rent, which is increased when higher rates price people out of purchasing a house. i have noticed, however, that these people didn't complain that the inflation rate was distorted down by the same mechanism when rates were going down.

if we mean by inflation "that which is measured by the [core?] cpi," then you're right. higher rates will show up as higher owner's equivalent rent.

what i'm wondering is whether a dollar crisis can cause a deflationary crisis, a collapse of prices for all assets as people try to get liquid?

Regarding the definition of inflation, I found the following to help my understanding of what inflation may be and the problems, according to this author (Michael Shedlock), of measuring inflation.

http://globaleconomicanalysis.blogsp...eck-is-it.html

It is fairly long, but he concludes with:

1. Inflation is best described as a net expansion of money supply and credit.
2. Deflation is logically the opposite, a net contraction of money supply and credit.

[zmas28]

Can we have inflation & deflation at the same time?

I think the usual definition of inflation/deflation is growth/contraction of the money supply in relation to the goods & services available, & is taken to be in the aggregate sense, ie, not sector or item related. But it seems to me that if there is too much money chasing Item A this upsets the exchange balance between the dollar on 1 hand, and Item A on the other (supply-demand balance), resulting in inflation or deflation of item A. We see this when discussing currency exchange rates also. It is possible for the dollar to be under-valued measured against New Zealand currency, but over-valued (inflated) in relation to the renminbi.
So is it not possible to have inflation in some sectors (the stock market or real estate sector) while having deflation in others (e.g., computer industry due to cheap imports) at the same time?
I think the unravelling of debt, due to loan defaults & debt being taken off the books, represents a deflationary effect on the associated sectors (banking, home construction, etc): Sector X. The external deficits, associated with over-consumption by the American consumer, would seem to represent inflationary pressures. The return of dollars to the US, were they to go into Sectors Y of the economy, would result in inflationary pressures in Sectors Y of the economy. Of course, Sectors X and Y would impact the rest of the economy also, presumably to reduced degrees.
Anyway, my point is that shouldn't this be looked at on a sector by sector of the ecoonomy basis, rather than just on the aggregate?

[blazespinnaker]

Anyway, my point is that shouldn't this be looked at on a sector by sector of the ecoonomy basis, rather than just on the aggregate?

Yes though I think the original intent was a valid one - that a dollar crisis could lead to a significant contraction in the economy and at a time when assets have been inflated, we could seem them significantly deflated.

[zmas28]

Investment implications

My line of thought was to determine investment direction during the upcoming period. I think we are in a secular bear stock market for some time, but its not clear to me as to whether this would be in an inflationary environment (like the 70's) or whether history would rhyme with the Japanese deflationary experience.
In an inflationary environment, real assets like commodities and real estate are expected to do well. In a deflationary environment, its cash.
It appears that there are strong deflationary pressures (represented by the huge debt overhang) and strong inflationary pressures (represented by the declining dollar and rise in commodity prices).
Then, of course, if one believes the Kondratieff cycle model, we are in for a rough deflationary "winter" period.
There's a school of thought that says that the Fed will respond to deflationary pressures by trying to reflate the economy, so we would end up with high inflation. Akin to the ka-Poom theory? But looks like the last time around, the Fed had a difficult time getting us out of the hole. Also, I've read somewhere that it gets more difficult each time and that it took about $4 of credit extended by the Fed to generate $1 of GDP.

In trying to think this through, I thought it might be more a question of individual sectors of the economy being affected in different ways. The trick is to determine which asset classes would perform best on a relative basis.

I'm a complete "newbie" at this, and I'm regurgitating what I've absorbed on the Internet including Eric's really insightful stuff. But its an important question, I think.

[blazespinnaker]

Yes, I think it's an expectations game. As longs as the fed has credibility they can reflate the economy ... Two things are working against this fed in that department:

- greenspans recent reflation
- switchover in chairmans

So, you're right, I think any attempt to reflate at this point will lead too massive inflation... best just to bite the bullet and pay the piper.

There is, of course, the muddle through school of thought which has a suprisingly good track record. And that is we'll see higher inflation, a weaker dollar, and lack lustre returns, but nothing overly painful in any particular sector ... at least nothing so bad that you should take a capital gains hit in order to rebalance your portfolio.

[zmas28]

I guess a possible scenario is that if deflation were to set in, people started to save & become more debt averse, then that would strengthen the dollar. Would this mean that interest rates would have to rise as debt instruments would have to provide greater yield? With the dollar now buying more, our international creditors would buy more US assets (companies perhaps, China's ill-fated pursuit of Unocal comes to mind). US international debt could unwind in this way, through reduced demand for imports and sale of US assets.

[jk]

I guess a possible scenario is that if deflation were to set in, people started to save & become more debt averse, then that would strengthen the dollar. Would this mean that interest rates would have to rise as debt instruments would have to provide greater yield? With the dollar now buying more, our international creditors would buy more US assets (companies perhaps, China's ill-fated pursuit of Unocal comes to mind). US international debt could unwind in this way, through reduced demand for imports and sale of US assets.

i don't see why an increase in savings would strengthen the dollar. an increase in savings would slow consumption, including consumption of imported goods. but it would slow the economy in general and lower interest rates, making the dollar less attractive.

[zmas28]

My thought here was that reduction in domestic spending would reduce the amount of money in circulation in a deflationary setting, resulting in a general price drop of US assets, making them more attractive to international buyers.

[Jim Nickerson]

Interest rates, US$ Index, Inflation-Deflation

i don't see why an increase in savings would strengthen the dollar. an increase in savings would slow consumption, including consumption of imported goods. but it would slow the economy in general and lower interest rates, making the dollar less attractive.

Below is a quote by Henry Kaufman noted at http://www.safehaven.com/article-5429.htm I found Kaufman's thoughts worth reading.

"Kathleen Hays: "Final moments, how high do you expect the Federal Funds rate to go?"
Mr. Henry Kaufman: "I really feel that somewhere in the next twelve months we'll head to at least 6%.""

Carl Swenlin 5/5/06 discussed the US$ and showed a nice monthly chart of US$ Index since 1983 http://www.decisionpoint.com/ChartSp...60505_USD.html This appears worthwhile to look at because it clarifies where the $ is relative to its peak almost 20 years ago.

The current chart of the US$ Index suggests to me that the $ is strengthening, why I am not exactly sure, but pershaps because of the current rise in interest rates.


With regard to EJ's Ka-Poom Theory http://www.itulip.com/retrospective2006.htm
and since John Serrapere's comments http://www.itulip.com/peakriskmay2006.htm
I have been trying to comprehend what the relationship has been between Deflation and the markets (S&P 500 as a proxy). My wonderment is whether or not presently the so-called "Ka" is upon us--a questioned asked recently somewhere in these fora, and which I am not inclined to find and cite directly?

Below is a graph of the S&P 500, the PPI and CPI, and the PPI minus the CPI. The CPI and PPI data through the last reporting were taken from http://www.bls.gov/opub/ted/2006/may/wk3/art04.htm and http://www.bls.gov/opub/ted/2006/may/wk3/art03.htm. If you wish to look at the data used to construct the graphs, click on the link beneath the graphs.



If one looks at the trends of the CPI and PPI, light green and light blue lines, they are currently up for both. The same was true in 1999-2001, the PPI peaked at 4.8% in Jan. 2001, and the CPI peaked at 3.8% in Mar. 2000, and hit 3.7% in Jan. 2001. By Jan. 2001, the S&P 500 was down 10%, measured by month-end closings, from its peak at end of Aug. 2000.

My conclusion (and Henry Kaufman's sentiment) is that interest rates have a ways to go upward--how far they may go up, I have no idea.

Secondly, I do not see the US$ collapsing for the moment.

Thirdly, using what I think might be useful definitons of Inflation and Deflation noted above in item #7 of this forum, and supported by Kaufman's perception that credit still is not "tight," I believe we are a ways in front of the "Ka."