Versus Deflation; Explanation For Low Interest Rates
By Victor Sperandeo with the Curmudgeon
Preface: This article is a follow up to an earlier post titled Is Deflation Really the Problem or Will Hyper-Inflation Begin in 2014?
Victor takes the lead and the Curmudgeon follows with his comments on the risk of deflation and continued global central bank easing.
Editor's Note: We were originally planning to do a postscript related to several recent articles (especially gold bottoming and the oil price decline) by publishing Q&A from readers. Time and space doesn't permit that, but please keep the questions, comments, and suggestions coming (email: firstname.lastname@example.org).
Victor's Hyperinflation Update:
On February 16, 2010 I made a speech for a charity event titled "Hyperinflation: A Statistical Inevitability." The idea came to me after reading the CBO annual report: "The Budget and Economic 2010-2020," published January 31, 2010, which wasn't at all credible. My talk was suggested as a warning that unless the trends of U.S. debt growth changed, we would eventually suffer hyperinflation.
After the 2012 Presidential election, I proclaimed in writing and speeches that hyperinflation was a certainty. At the July 2013 Atlas Summit, I talked on the same topic, which the Curmudgeon summarized in Highlights of the Atlas Summit.
However, I never put a date on my hyperinflation forecasts, as it's impossible to predict. That's because it's primarily a psychological event, driven by loss of faith in a country's currency (i.e. who knows when will the citizens of a country run from its currency?).
Most people confuse Inflation with Hyperinflation (HI). Although they sound similar, they have almost nothing to do with one another.
· Inflation from Webster's Seventh New Collegiate Dictionary: "is an increase in the volume of money and credit relative to the available goods (and services being produced) RESULTING in a substantial and continuing rise in the general price level." (Emphasis added). That's what occurred from the late 1970's to 1981.
· HI is an increase in an inflation measure, e.g. CPI of 50% in one month defined by Professor Phillip Cagan (1956) in "The Monetary Dynamics of Hyperinflation.” Professor Peter Bernholtz's book “Monetary Regimes and Inflation,” which counts 29 occasions that met this definition. I added Zimbabwe's HI which occurred after the above referenced book was published. 29 of these HI events occurred since 1920, when the world went off the "Bimetallic Standard" to the "Discretionary (fiat) Paper Standard" after WWI.
The difference between these two types of inflation is that the price level is not rising in HI. Instead, the currency is falling, because the people don't want it and are aggressively selling it. Think of people believing their bank was going to fail which instigates a run on the bank to get your money out.
The record sale of a currency was a decline of 75% (causing HI) in one day (see page 214 of "Fiat Paper Money -the History and Evolution of our Currency," by Ralph Foster). According to Foster, 450 currencies died or became worthless from 1900-2010.
Professor Steve Hanke of Cato Institute counts HI's occasions in the low 50's as he double counts the same HI event, e.g. if one month inflation rate is below 50% then he starts over.
Before 1920, HI was only experienced during the French Revolution (1790-1795). Here's a list of the top 10 HI events (worst first):
Hungary 1946, Zimbabwe 2008, Yugoslavia 1994, Germany
1923, Greece 1944, Poland 1921, Mexico 1982, Brazil 1994, Argentina 1981, and
In major countries/regions like the U.S., UK, EU, Japan, or Brazil has a central bank ever let a country/region go bankrupt? Not a chance!
Bankruptcy of a nation has not occurred in history when there's a national debt owed to its own citizens. But when a country owes money to foreign governments and then defaults, it could go broke (e.g. if Greece defaults on its debts to the EU). However, Russia defaulted on its foreign debt in 1998, devalued the Ruble, and survived.
When a nation's economy is failing, needs or wants money for any reason, it has typically printed paper via IOU's (euphemistically stated as "Federal Reserve Note's" in the U.S.) to pay its bills. Alternatively, the country devalues its currency, like Argentina has repeatedly done with its peso (which was once pegged 1:1 with the dollar).
On the contrary, I can't name a single instance where deflation has been allowed to occur. Think of all the instances of QE in so many countries/regions since the Sept 2008 financial crisis began (when Lehman Brothers was permitted to fail). If QE doesn't work, the Keynesians say do more! That's now happening in Japan and the EU as we've previously reported in recent Curmudgeon posts.
If QE fails AGAIN to boost economic growth (it hasn't succeeded in stimulating the U.S. economy or any others yet), several scholarly authors have recommend printing cash and giving it directly to the people, i.e. a real helicopter drop!
In my opinion, HI in the U.S. will be precipitated by rising interest rates, and/or a declining dollar. Let's look at one possible scenario.
In its Update to the Budget and Economic Outlook: 2014 to 2024, the CBO predicts a $27 trillion debt in 2024 - not counting off budget items or unfunded liabilities. At an average interest rate in the last 54 years of 6.2%, that comes to $1.7 Trillion in interest payments owed on the debt in 2024.
[Does anyone believe we will never see an average of 6% interest rate again?]
Note that CBO also forecasts ~$5 trillion in taxes/revenues to be collected in 2024. Therefore, approximately 34% of all government revenues ($1.7 of $5 trillion) would be needed to pay interest on the national debt. Compare that to the 6% [debt interest amount divided by government revenues] today and ask yourself where will the extra 28% come from to pay interest on the debt in 2024?
Today, the biggest government expenditure is social security at 23.5% of total federal government spending. That's unlikely to be cut. So again, where will the federal government get the funds to pay interest on the national debt in 2024? Might the funds come from money printing?
Borrowing by rolling over principal is one thing, but will people lend money to the government and hold the currency if the government is printing massive amounts to pay the interest?
The U.S. has made it as clear as daylight that it will never allow a deflationary depression. Ben Bernanke has proven that with his ZIRP and QE programs. Japan and the ECB are now pushing the pedal to the metal with their extremely aggressive debt monetization programs.
In conclusion, the debate of deflation and depression is a loser to HI when "the fat lady sings," based on the historical evidence.
Perspective on Ultra Low Yields & When Debt Matters:
With the current 10 year Treasury note yielding 1.64% and the 30 year Treasury bond at a near record low of 2.22%, one would suspect we are in the 1950's golden decade or perhaps the Garden of Eden? More astonishing is that the 10 year TIPS note yields only 13 basis points (bps). Does anyone in the world believe US inflation will be 13 bps over the next 10 years?
The yields are based on relative yields not the future. Comparable maturities yield even less in Europe1 and Japan, so foreign money comes to the U.S. in search of relatively higher (but still meager) yields.
1The 30 year German bund is at 0.95%, while the 10 year bund is at 0.30%. All the foreign and U.S. government bond/note yields are lower now than they were at the nadir of the 2008-2009 financial crisis.
Money managers are paid to invest with other people's money, so risk is very low on their scale of concerns. When the inevitable bond or stock crash comes almost everyone loses. It seems that today's money manager is not worried on losing assets on the way down - only on missing opportunities on the way up.
Debt is never a problem till you can't pay it, or no one wants to buy it anymore of it. The U.S. has always been able to borrow fiat money, since the government can sell it to itself - from the U.S. Treasury to dealer banks to the Fed which creates money out of thin air by increasing bank reserves.
Normally debt doesn't matter, because the government's central bank creates the money needed to borrow from itself (i.e. the Fed creates money to buy U.S. government debt, thereby financing the budget deficit). However, when a central bank has to print massive amounts of interest to pay its debts, then the debt becomes a serious problem. We've discussed this at length in a previous post titled Increasing U.S. Debt, Interest Payments, and Why It Matters Now!
Let's consider what might happen if China decides to sell a large part or all of their trillions of US dollar holdings and the only buyer is the Fed? Would that amount of printing paper dollars overwhelm the financial system and cause the greenback to drop like a rock?
The holding of any asset is always based on the confidence of someone else willing to accept it. When virtually no one has confidence in the debt -again like a run on a bank - it becomes worthless. The only question is when?
The contradictory nature of the U.S. government mentality is best stated by Artemus Ward: “Let us all be happy, and live within our means, even if we have to borrow the money to do it with."
1. In the 18-nation euro-zone, the already low inflation rate fell significantly into deflation over the last two months (see chart below).
Deflation makes debt harder to repay. Seven euro-zone countries are forecast to have public-debt-to-GDP ratios of over 100% next year; the proportion of loans in default is rising in Portugal, Italy and Greece. As a result, there are now serious worries that the euro zone will succumb to a “triple-dip” recession.
2. In the U.S., the Fed’s 2% inflation target was approached last summer, but the rate has tumbled to cause fears of deflation in the U.S. Sharply lower oil, energy, and industrial commodity prices are exacerbating that deflation scenario.
3. Deflation fears explains why the 30 year U.S. Treasury bond yield has set an all-time low of 2.22% in 2015! Let's see how unusually striking that is historically.
As can be seen from the chart below, the 30 year T bond yield was always ABOVE 7.5% from Nov 1, 1977 till Aug 1, 1992. It is substantially BELOW its previous low of 2.58% set April 30, 2012. How can that be explained if the U.S. is in such a sustained economic recovery/expansion?
4. Despite extraordinarily low bond yields and negligible/zero/negative short term interest rates, global central banks continue to ease. It appears that's almost entirely due to the threat of deflation, as described and illustrated above. It's not only the SNB and ECB that've taken steps. The strong trend toward monetary easing has gathered steam all over the world:
· The Bank of Canada’s surprise 25 basis-point cut to 0.75% was primarily driven by a more- cautious economic outlook tied to the impact of lower oil prices on investments, exports and households.
· The Monetary Authority of Singapore’s (MAS) decision to ease monetary policy by reducing the slope of its policy band for the Singapore dollar was a response to a deteriorating inflation outlook caused by the fall in global commodity prices. MAS could switch to a zero-appreciation policy if economic growth sputters.
· The Reserve Bank of India cut its repo rate, its key lending rate, by 25 basis points to 7.75% earlier this month. The move was aimed at bolstering growth. The bank expressed confidence that is winning its battle with inflation – thanks to lower oil prices – and could therefore focus on boosting flagging growth.
· New Zealand dropped its tightening stance last week and announced its expectation that interest rates will remain on hold for “some time.”
· The Reserve Bank of Australia (RBA) has a meeting next week. The bank’s preferred inflation measure is within the 2% – 3% target range, but the sluggish non-mining economy could push the RBA to cut rates.
Where will it all lead - a race to zero or negative nominal interest rates?
The capital flows and currency market reaction to all these changes will be important to watch in coming weeks. Stay tuned!
Till next time...
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Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.
Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies. Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.
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