Credit inflation, Deflation: Prechter Interview

[jk]

Re: Credit inflation, Deflation: Prechter Interview

as i have said in other threads, i worry about the possibility of daisy-chain bankruptcies and counterparty failures in derivatives contracts leading to a deflation. i think this is of much lower probability than significant inflation, but a non-zero probability nevertheless.

on contrarianism- even if the members of this bulletin board were unanimous in some opinion, that would not make it "the consensus." contrarianism works only at turning points [most of the time the trend is your friend] and vis a vis the consensus of opinion of the whole market, not the opinion of the small minority of hypervigilant and obsessional types who write posts like this.

[Jim Nickerson]

Re: Credit inflation, Deflation: Prechter Interview

I don't see how the powers that be could allow deflation. The large investment banks, the Federal Reserve and the gov will to anything to hold power. If that means making the dollar worthless, so be it.

If manipulating financial system does not work, they will intervene directly in the economy. We can only hope, we are still better off, than Weimar Republic, because ours is credit inflation. At certain moment this difference will disappear. We *are* going KaPoom, and the Poom will be huge with the subsequent huge deflation, but this time the prices will go down together with the political system.

Below is from Prechter's interview regarding deflation. Unlined emphasis JN's.
10/7/06
http://www.financialsense.com/transcriptions/2006/1007prechter.html


JIM Puplava: If you were to make your case for deflation right now, what would be the key factors supporting that view?

BOB Prechter: The credit bubble: the fact that we do not have currency inflation as much as we have credit inflation. And credit bubbles have always imploded. The amount of dollars out there that are greenbacks – actual cash – is miniscule compared to the dollar value of credit instruments. So in my view the Fed is utterly powerless to prevent the ultimate deflation of the credit bubble. And some people say, “Well, they can print money.” Fine, that would just make the credit bubble collapse faster as soon as bondholders realize that’s what they were doing. There’s no way out of it. So that’s the argument.

It seems to me you’re also implying, “what are the signs?” And we don’t have any yet, because we haven’t turned down in the 5^th wave in the stock market. I think we might have peaked in oil – I put out a report on oil in July; we may have seen the tops in gold and silver. I think I called silver very well; gold went way beyond where I thought it would, but now it’s back into a reasonable area. So I think there are signs. Just like in the housing area, there was a tremendous speculation all supported by credit. Credit is behind all of the asset bubbles – not cash, as say in Weimar Germany in 1923; that was a different situation. It’s all IOUs; somebody’s collecting interest on that and someone on the other end is promising to pay. And when all of that collapses I think we’ll see deflation.

Below are points of Hussman regarding relevancy of the FOMC. Underlined emphasis JN's.

October 2, 2006

http://hussmanfunds.com/wmc/wmc061002.htm

Superstition and the Fed John P. Hussman, Ph.D.
All rights reserved and actively enforced.


Superstition and the Fed

There's no question that the Fed's open market operations determine the total supply of currency and bank reserves (the “monetary base”), but that's a power of little practical effect. There are three problems with putting a lot of faith in the Fed's activities to significantly influence the economy, to “determine interest rates,” or even to control inflation:

First, foreign holdings of U.S. Treasuries swamp the holdings of the Fed by almost 3-to-1. Moreover, the Fed's holdings of Treasuries hardly fluctuate from year-to-year, particularly compared with the volatility of foreign holdings. Buying and selling of U.S. Treasuries by foreigners (particularly foreign central banks) swamps the impact of the Fed by more than 10-to-1.

Second, although the Fed can vary the monetary base, those fluctuations have virtually no effect on bank reserves. In the past 15 years, every single dollar of growth in the monetary base has been withdrawn from the banking system in the form of currency. Why? The banks don't need these reserves because the reserve requirement rules were changed in the early 1990's to apply only to checking accounts. And even the balances in these checking accounts are increasingly swept into accounts free of reserve requirements. Yes, everything I taught to my undergraduate economics students about “money multipliers” has become hogwash. To get a feel for this, since 1995, the monetary base has grown by nearly $400 billion. Meanwhile, the total amount of bank reserves has actually declined by $15 billion – from $58 billion to the current $43 billion.

That's right. The total amount of bank reserves in the U.S. banking system is just $43 billion, and that's all the FOMC is responsible for controlling. In an economy with a GDP of $13 trillion and a public debt of over $8 trillion, the Fed Funds rate is based on $43 billion of dough.

Which brings us to the third problem with the belief that the Fed matters: since bank reserves are only required on checking deposits, which are a small fraction of the sources from which banks can lend, influencing the amount of reserves in the U.S. banking system has no effect on the volume of lending in the U.S. banking system. (This should be immediately evident given that reserves are a pittance, economically speaking, and have even declined over the past decade, while bank lending clearly has not). Still believe that “injecting reserves into the banking system” matters? It's just not in the data.

Sure, if the economy starts to slow and inflation cools, the market will tend to reduce short term interest rates. The Fed will respond to the same data by cutting the Fed Funds target, but this will be a response, not a cause. If instead inflation pressures persist, the market will drive short term interest rates higher on its own. The Fed will choose not to cut the Fed Funds target. Investors will be disappointed in the Fed, but its actions again will be a response, not a cause.
Now, it's certainly true that changes in Fed-controlled rates are convenient and relatively predictable events that banks use to coordinate their own rate changes. So you'll generally see the prime rate being changed by a majority of banks at the same time that Fed-controlled rates are changed (to coordinate rate changes at other times would smack of price collusion). Still, the Fed essentially responds to market-driven interest rate pressures – it doesn't cause them.

Except in times of financial crises, when people are trying to convert their deposits into cash and the Fed has a truly legitimate role as a “lender of last resort,” the Fed's moves are essentially irrelevant.

Comments:

1. Prechter says Fed is utterly "powerless to prevent the ultimate deflation of the credit bubble," and when credit collapses he believes there will be deflation, and in the interview he looks for a depression and not a recession.

2. Hussman argues that the Fed's moves are basically irrelevant.

If it is a fact that there are real limits to what the Fed can do, then fightthepower suggests are there other entities that can likely halt a credit collapse such as large investment banks or something else in the government. How would large banks or some other governmental entity halt a credit collapse?

medved suggests "they will intervene directly in the economy." Who are "they" are or what would be the interventions in the economy?

A more basis question: What could make the credit bubble collapse?

[jk]

Re: Credit inflation, Deflation: Prechter Interview

jim, you underlined the key passage in hussman's piece with regard to a deflationary collapse:

Except in times of financial crises, when people are trying to convert their deposits into cash and the Fed has a truly legitimate role as a “lender of last resort,” the Fed's moves are essentially irrelevant.

in the event of a deflationary crisis the fed will be creating reserves to fulifill its role as lender of last resort, and thus to liquify the banking system, and via the banking system liquify any other entities it chooses. this was bernanke's point in his helicopter speech: "making sure IT [deflation] doesn't happen here."

in my own mind, i think the only issue is the timing/speed of a deflationary crisis. the more time it takes to play out, the more time the fed has for its actions. if something unfolded very rapidly, it seems to me that the mechanisms might seize, and prevent effective fed action. but this is pure speculation based on little knowledge of how those "mechanisms" actually work.

you ask "What could make the credit bubble collapse?"
there have been peiodic crises in the financial system, triggered by the failure of financial institutions - continental illinois, penn square, the s&l's en masse, ltcm. these problems have always been "contained." but in our complex, derivative strewn world, perhaps a failure could occur which would not dampen out, but would cause a chain reaction. if i recall correctly, the 1929 crash was triggered by the failure of a small austrian bank.

[Uncle Jack]

Re: Credit inflation, Deflation: Prechter Interview

Here are some actual numbers from the Central Florida Real Estate market:

I had a chance to review all 8 counties last night and here is the total data for the Mid-Florida region, using averages. The trends in the smaller counties were consistent with the larger ones in all areas.


*
July-03
July-04
July-05
July-06


Monthly sales
738.6
905.3
961.8
685.4


Avg. Days on Market
80.4
66.3
41.6
67.8


Current Inventory
2,486
1,608
1,577
6,394*

*Triple pre-bubble average!

Prices will drop, severely in my opinion, or you're going to have a bunch of discouraged sellers taking their homes off the market. If they put them up for sale due to financial budget strain, look for more foreclosures and a pullback in consumer spending.

[Uncle Jack]

Re: Credit inflation, Deflation: Prechter Interview

Omigod that looks horrible. here's my post where I looked at Real Estate for Central Florida. much easier to see what I said there:

http://www.myunclejack.com/index.php...l-estate-math/

[bart]

Re: Credit inflation, Deflation: Prechter Interview

...
http://hussmanfunds.com/wmc/wmc061002.htm
...

Superstition and John P. Hussman's view of the Fed


I'm concerned about what appears to be Mr. Hussman's incomplete view of the Fed as represented in the article, what it has done, is doing and what it is capable of doing.


On the first point about foreign ownership of Treasuries being triple what the Fed has in the SOMA account, of course that's true. But it complete ignores issues around markets being determined at the edges, not in broad measures. It also completely disregards, among other things, the Fed's Securities Lending portion of its Open Market Operations. I submit the following chart, showing that changes in those SecLend operations precede changes in the 10 year T-Bond rate. I wouldn't call it inconsequential, to say the least.




His second point about monetary base and reserves also ignores the very large effect that the changes in base and reserve requirments in 1995 had on the economy and stock market. I refer you to EJ's excellent article covering those changes that were made in 1995.


On his third point, and not taking into account how wise it would be, there are still some types of accounts that have non zero reserve requirements. In other words, there does exist a lot more dry powder than can be used if the Fed desires to use it.
I offer as an additional point, the reverse of what he noted - that $15 billion drop in reserves had a *very* large effect. I also note in passing that reserve requirements were adjusted downward in late 2005, and that change is beginning to affect the money supply ( there is a significant lag though, as is normal with changes in monetary policy).

Regarding the Fed's moves being irrelevant, I just plain can't buy it. That's saying that the central bank of a country, the entity basically in charge of money and credit and with large amounts of legal and regulatory and Open Market Operations power, is supposed to be ignored?

I've already shown the SecLend operation and its correlation with interest rates. Here's another correlation, this time with the Fed's temporary repo Open Market Operation and the Dow.





Lastly, please don't get me wrong here. I am not maintaining that the Fed is the be-all and end-all for the economy and money issues... but what I am saying is that its quite far from as irrelevant or powerless or inconsequential as Mr. Hussman seeked to portray it.

[Charles Mackay]

Re: Credit inflation, Deflation: Prechter Interview

Bart, I agree with you that both Hussman and Prechter have an incomplete view. Their free market views are very 19th century. We are in an era where even the integrity of electronic voting is suspect.

Does anyone really think that bonds would be this expensive (over par) after a tripling in the price of gold and a doubling and tripling of housing... not to mention oil and commodities ... if there wasn't foul play?

Anyone who thinks that is extremely innocent and naive. The problem is people have yet to uncover the data that's important... the yen carry trade, the derivative purchase of bonds, etc... and much more

[bart]

Re: Credit inflation, Deflation: Prechter Interview

...
The problem is people have yet to uncover the data that's important... the yen carry trade, the derivative purchase of bonds, etc... and much more

Agreed... and my favorite one that's undiscovered or unrealized or un-admitted by most - the lies involved in the CPI.

Regardless of what one thinks of him, I think this applies:
"Find the trend whose premise is false, and bet against it."
-- George Soros

[Finster]

Re: Credit inflation, Deflation: Prechter Interview

Jim, I've been following Prechter for years now, ever since I read his At The Crest in 1995, and have very high regard for his market insight. Nevertheless, he has been way off the mark in some of his most important forecasts, and I believe it is because of his tendency to take the dollar as a value unit too literally. For example, he will apply Elliott analysis to a long term chart of the Dow and conclude that some level achieved decades ago is still relevant without sufficiently accounting for the fact that the dollar of today itself - in which the Dow is measured - is far different than that of decades ago.

In fact after he called for deflation in 1995, we did get deflation. Two significant waves, one in 1997-1998 and another in 2001-2002. Yet he didn't even recognize it for what it was, because he was expecting it to look much different. He is still waiting for it. Meanwhile, the Fed so aggressively inflated in 2003-2004, that it is long over.

Could we get another round? Sure. There is even some evidence of it in house prices. But interest rates are still too low, the monetary environment too liquid, and the Fed too inflationary to persuade me that it is a bigger risk than continued inflation.

But let's set aside vague generalities and look more concretely at the question of what an optimum investment posture is. I've been quite skeptical of the stock market since the first major rally out of the 2003 lows, partly out of deference to Prechter. But a great deal has changed since the radically overvalued state of the market a few years ago, and we need to take those changes into account.

Looking at current earnings, the stock market is quite reasonably valued at these levels. On the other hand, earnings themselves are historically high in relation to the size of the economy. These two factors are in tension with each other. My view is that the latter outweighs the former. But not so overwhelmingly that we should be eschewing stocks for cash and bonds. The problem is that to whatever extent the stock market is overvalued, cash and bonds are more so.

Commodities, including hard money, futures indices, and other physical asset investments, have been where most of the action has been the past couple of years. Lately they have sold off sharply, and as a class represent a better value than stocks. So my overall view is that commodities should be overweighted, stocks slightly underweighted, and bonds substantially underweighted. My current target mix is about 36% hard money and commodity indexes, 48% stocks, and 16% bonds and cash, relative to a neutral weighting of 25%, 50%, and 25%, respectively.

Unlike Prechter, not to mention most conventional economists, I do not believe inflation is under control. The pullback in commodity prices has fooled many into thinking the Fed has accomplished the proverbial Goldilocks nirvana of bringing inflation down; a "soft landing" without a recession. But the Greenspan Fed did not allow the last recession to do what it needed to accomplish - and it appears unlikely the Bernanke Fed will either - and that is include a significant consumer spending retrenchment. The inflationary price increases have not disappeared, but temporarily shifted from the commodity arena to the stock arena. Unless and until the Fed actually gets some backbone and tightens enough to permit an actual consumption-led recession, this pattern is likely to continue.

[bart]

Re: Credit inflation, Deflation: Prechter Interview

... without sufficiently accounting for the fact that the dollar of today itself - in which the Dow is measured - is far different than that of decades ago.

Hi Finster, good to see you posting about the raw facts again. :-)


Ain't it the truth on the dollar and inflation. Here's a couple of new charts in the US household net worth area that I finally got around to producing. The data is from Z1 (L10 tables, specifically), and the CPI numbers are from the BLS, with adjustments per John Williams data from 1982 on. Its not a pretty picture, and even surprised me some.

Note that the "correction" data on raw net worth (the gray line) has been multiplied by 5 just in order to show changes - otherwise it looks very close to a flat line for decades. Inflation effects are *so* under realized... *sigh*

[Jim Nickerson]

Re: Credit inflation, Deflation: Prechter Interview

Could we get another round [of deflation]? Sure. There is even some evidence of it in house prices. But interest rates are still too low, the monetary environment too liquid, and the Fed too inflationary to persuade me that it is a bigger risk than continued inflation.

Glad you are back, Finster, and thank you for your insight.

I brought up a similar question above in #5 while you were away hoping you would pop in an give your opinion. The point, I was attempting to raise, concerns the difference in how John Williams is depicting inflation, how the CPI is depicting it, and how your FDR is depicting it.

Now even you suggest above inflation is a bigger risk, yet as I read the FDR since 3 years ago, it has disinflated from about 17% inflation to about 7.5% as updated through today. What is your explanation of why the trend in the FDR is distinctly contrary to the CPI and Williams's SGS Alternate? Just to perhaps pick at you a bit, why are you apparently more concerned about inflation, when your FDR say otherwise. Are you casting doubts on your FDR? I am sure you can explain.

[Finster]

Re: Credit inflation, Deflation: Prechter Interview

Hi Finster, good to see you posting about the raw facts again. :-)


Ain't it the truth on the dollar and inflation. Here's a couple of new charts in the US household net worth area that I finally got around to producing. The data is from Z1 (L10 tables, specifically), and the CPI numbers are from the BLS, with adjustments per John Williams data from 1982 on. Its not a pretty picture, and even surprised me some.

Note that the "correction" data on raw net worth (the gray line) has been multiplied by 5 just in order to show changes - otherwise it looks very close to a flat line for decades. Inflation effects are *so* under realized... *sigh*

Yeah how about that ... the facts! And indeed, you hit a bull's eye with the comparison between nominal net worth and the same adjusted for consumer prices. Living standards have not advanced near what our Ministry Of Plenty would have us believe. For sure, the wonders of soaring stock prices and house prices we've heard so widely touted over the past decade represent inflation more than anything having to do with real wealth. Inflation feels good while the prices of stuff we own are going up, but when it finally filters into the prices of stuff we buy, the illusion falls flat.

[Finster]

Re: Credit inflation, Deflation: Prechter Interview

Glad you are back, Finster, and thank you for your insight.

I brought up a similar question above in #5 while you were away hoping you would pop in an give your opinion. The point, I was attempting to raise, concerns the difference in how John Williams is depicting inflation, how the CPI is depicting it, and how your FDR is depicting it.

Now even you suggest above inflation is a bigger risk, yet as I read the FDR since 3 years ago, it has disinflated from about 17% inflation to about 7.5% as updated through today. What is your explanation of why the trend in the FDR is distinctly contrary to the CPI and Williams's SGS Alternate? Just to perhaps pick at you a bit, why are you apparently more concerned about inflation, when your FDR say otherwise. Are you casting doubts on your FDR? I am sure you can explain.

You sure have a way of coming up with good questions, Jim! Keep holding my feet to the fire. Let’s start with the second part of the question and work our way back to the first.

The FDR - the rate of inflation derived from the FDI - has indeed come down over the past couple of years or so, from over 15% to around half that. But 7.5% inflation is still a big problem, all the more so when interest rates are significantly less than that. Fed funds and long term treasury rates alike in real terms remain negative, meaning that Fed policy and the overall monetary environment remains inflationary. The Fed has been so intimidated by the prospect of a housing market debacle and recession that inflation fighting, despite all the rhetoric to the contrary, has taken a back seat to long term economic prospects and monetary stability. Moreover, there is still so much money sloshing around the globe from Greenspan's last big printing spree that the effects of that money continue to exert upward pressure on the prices of assets, commodities, and wages.

Keep in mind that any financial forecasting is always a probabilistic endeavor, and we can never say never. Could the trend continue into deflation? Sure it could. It’s just that all the evidence I can muster suggests that such an eventuality is far enough away from where we are now, or a small enough probability, that our investment posture should continue to be more aligned to the risk of continued inflation. So while the asset class balance I cite above does include some cash and bonds, they are significantly less than what I would hold in "normal" times.

I should also point out that I consider that mix a quite conservative one, one targeted to real capital preservation over most time frames exceeding a year at worst. Counterintuitive as it may seem, however, in my experience the greatest gains have tended to stem from efforts at avoiding loss on an inflation-adjusted basis.

I’m also including a chart to illustrate how that mix, based on my model, has evolved over time. It is interesting to note that while cash and bonds have been becoming more attractive with the passage of time, the rate at which they are doing so is historically lame. Not to mention from an extraordinarily low base.

The differences between the CPI, the Williams CPI, and the FDI are fairly simple. Both of the former target consumer prices. The Williams CPI is an attempt at a more honest picture of consumer prices than that promulgated by the US government. It tends to rise and fall with the government version, but generally shows a higher overall level of inflation. As a measure of consumer prices, the Williams CPI is in my view much more realistic.

The FDI, on the other hand, is a broader measure of inflation - in general - from the get-go. Think of the Dow Jones Industrial Average as a measure of the price performance of the stock market. Out of thousands of stocks listed and traded in the United States, however, it only includes thirty of them. They are indeed the stocks of the largest and most important blue chip companies in the world, covering roughly on third of the capitalization of the US market, but nevertheless is not a complete picture of the stock market. At least someone who has been invested primarily in Nasdaq stocks for the past six or seven years would not have experienced anything like having been invested in the DJIA!

The FDI, to continue the analogy, is more like the S&P 500, or better yet, the Dow Jones Wilshire 5000. The latter represents basically the collective experience of all investors in US stocks. Unlike its better known Dow Jones counterpart, it has yet to attain new highs in this latest bull run.

Like the 30 stocks in the DJIA, US consumer goods and services are an important representative benchmark for the value of the US dollar, but incomplete. One important deficiency is that their prices are slow to react to changes in the overall global market value of the US dollar. There are a number of reasons for this, but the main one is that domestic wages are a major component of those prices. And wages simply don’t adjust rapidly. They are often set according to multi-year contracts and schedules. So if we look exclusively at consumer prices, we are usually going to be way late in appreciating changes in the value of the dollar and of inflation.

As a result, unlike the Williams CPI, the FDI does not merely tend to register higher inflation readings than the government CPI, but also tends to lead it very significantly and register shorter term trends. It is even tempting to look at the FDI as an inflation forecaster, but I prefer to think of it the other way around - that the conventional indices are simply very slow and sluggish and tend to tell you about inflation that is already well under the bridge.

To put it pithily, as measures of broad inflation, the CPI is low and slow, the Williams CPI is merely slow, and the FDI is neither.

[bart]

Re: Credit inflation, Deflation: Prechter Interview

Yeah how about that ... the facts! And indeed, you hit a bull's eye with the comparison between nominal net worth and the same adjusted for consumer prices. Living standards have not advanced near what our Ministry Of Plenty would have us believe. For sure, the wonders of soaring stock prices and house prices we've heard so widely touted over the past decade represent inflation more than anything having to do with real wealth. Inflation feels good while the prices of stuff we own are going up, but when it finally filters into the prices of stuff we buy, the illusion falls flat.

"Interesting" too (in the sense of the old Chinese curse about living in interesting times ;)) that the house price appreciation hasn't had nearly as much effect on the net worth of the average household as almost all the news would have one think - and what an understatment that is as shown by the data below derived from Z1 and Census data.

Some raw numbers (1st qtr 2000 was the highest value in the last 10 years):

Date--------Net worth/Household-----with CPI+lies correction (base 100 = 1975)
1/2000---------$217,681-------------------$56,885
4/2006----------165,047---------------------34,936

There are roughly 2.7 people per household per the Census bureau for what its worth.

[bart]

Re: Credit inflation, Deflation: Prechter Interview

The FDR - the rate of inflation derived from the FDI - has indeed come down over the past couple of years or so, from over 15% to around half that. But 7.5% inflation is still a big problem, all the more so when interest rates are significantly less than that.

Now that I know what the FDR is, its pattern reminded me of one of my own charts. This one adds up all the various Fed actions I track - interesting how it peaked around 2003 around 15% and also has other broad similarities to the FDR.

...
The FDI, on the other hand, is a broader measure of inflation - in general - from the get-go. Think of the Dow Jones Industrial Average as a measure of the price performance of the stock market.
...

Like the 30 stocks in the DJIA, US consumer goods and services are an important representative benchmark for the value of the US dollar, but incomplete. One important deficiency is that their prices are slow to react to changes in the overall global market value of the US dollar. There are a number of reasons for this, but the main one is that domestic wages are a major component of those prices. And wages simply don’t adjust rapidly. They are often set according to multi-year contracts and schedules. So if we look exclusively at consumer prices, we are usually going to be way late in appreciating changes in the value of the dollar and of inflation.

As a result, unlike the Williams CPI, the FDI does not merely tend to register higher inflation readings than the government CPI, but also tends to lead it very significantly and register shorter term trends. It is even tempting to look at the FDI as an inflation forecaster, but I prefer to think of it the other way around - that the conventional indices are simply very slow and sluggish and tend to tell you about inflation that is already well under the bridge.

To put it pithily, as measures of broad inflation, the CPI is low and slow, the Williams CPI is merely slow, and the FDI is neither.

In your estimation, by how much does the FDI lead CPI?

Would it be correct to assume that the FDI attempts to measure *all* inflation, not just consumer prices, but also asset price changes?

Do you intend it to also measure US inflation on a global basis, in other words, also including dollar purchasing power gain or loss?