Deflating the Inflation Story

‘Australia’s first quarter inflation surprisingly soft’

CNBC 22 April, 2014

RBA boss Glenn Stevens hints official interest rates could drop lower than record low of 2.5 per cent’

The Daily Telegraph 4 July, 2014

Soft inflation numbers. Australian interest rates are at a fifty year low and possibly going lower. This is not how the script was meant to go.

The market will be waiting with bated breath on the second quarter CPI numbers. Perversely, a softer number could see the market rise. Lower interest rates makes fully franked dividends look even more attractive.

However, a lower number means our economy is stuck in a lower gear and cannot produce enough revs to change to a higher gear.

The sixth anniversary of the Lehman Brothers collapse is fast approaching. And after all the central bankers antics since then — suppressed interest rates and trillions of newly minted electronic money — the global economy is still barely treading water.

Time after time, nearly every growth forecast from the RBA, the Fed, the ECB, JCB, IMF, etc. is eventually wound back to a lower number. This cycle of optimism followed by realism has become a joke.

Here’s the latest rolling joke:

[US] GDP expanded at a 0.1 percent annual rate [Q1]Reuters, 30 April, 2014

U.S. GDP Dropped 1% In The First Quarter 2014, Down From First EstimateForbes.com, 29 May, 2014

U.S. GDP Dropped 2.9% In The First Quarter 2014, Down Sharply From Second Estimate’- Forbes.com, 25 June, 2014

A 3% difference in US GDP first quarter growth in the space of two months. How can you get it so wrong? Leave it to the government.

Even in Australia we are constantly revising our expectations on when the economy may gain sufficient traction to warrant an uptick in interest rates.

The following graph (courtesy of The Guardian) shows the market’s continual revision on when rates may rise. In February 2014, the expectation was for a rate rise around November 2014. With each passing month, the timeline has been extended. The latest bet is on a May 2015 rate rise. We’ll see.

Market expectations of RBA cash rate


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My forecast several years ago was for rates to fall well below 2% by the time the GFC had run its full course.

The reason for this interest rate prediction was twofold. Debt contraction and demographics (aging boomers) combining to create The Great Credit Contraction — a deflationary scenario not witnessed since The Great Depression.

Much like a balloon, the economy inflated when debt was ‘blown in’ and it’ll deflate as the debt ‘escapes out’.

The following chart from the Reserve Bank of Australia website shows Australia’s GDP growth rate since 1993.

From 1993 to 2008 (with the exception of 2000 due to the dotcom bust), GDP growth remained in the 2 to 5+ percentage range. During the latter part of this period, the Howard Government was paying down public debt. Therefore, the growth was being achieved largely by the private sector through debt funded consumption and the escalating mining boom.

Since 2008, those driving factors have softened. GDP growth has generally fallen into a lower band of 1.5 to 4%. A good deal of this ‘growth’ was on the back of our former treasurer’s carelessness with the public cheque book. Government expenditure via the Rudd/Gillard/Rudd era of harebrained stimulus schemes — $900 cheques to dead people, school halls, pink batts, etc. — gave a quantitative boost to our economic growth numbers. But not enough to get us back into the higher range of the 1993-2008 period.


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The prospect of deflation is something most economic commentators dismiss. The common belief is inflation will once again reignite the global economy, and it’ll back to business as usual.

In 2002, Ben Bernanke thought he could create inflation by simply ‘dropping money from a helicopter’. The GFC taught Bernanke the difference between theory and reality. In spite of Bernanke’s unprecedented and epic money printing efforts, inflation has not yet reared its head.

However, there are those who believe the Fed’s relentless money printing is bound to eventually unleash high inflation, even hyperinflation. In their opinion, we are destined to experience a 1970s style (or even worse, a Weimar Republic) period of double digit inflation.

In my opinion, the high inflation scenario is unlikely. The current period has some distinct differences to the 1970s.

For starters, the 1970s experienced two distinct oil shocks from the Middle East — both times sending the oil prices north of US$150 per barrel. The high cost of energy fed into every nook and cranny of the economy. Prices and wages rose in tandem to offset the rising cost of oil.

This contrasts sharply with 2014. The US is set to become a net exporter of light crude.

‘U.S. Oil Export Decision Opens New Potential Gateway for Industry’ – National Geographic 25 June, 2014.

The US is no longer beholden to the Middle East for oil supply. The alternative energy sources — wind, solar and nuclear — also make us less dependent on oil.

Second, the 1970s was a period of high wage growth (see chart below). The post-WWII manufacturing boom still meant employees and unions held sway over employers who needed workers to man the machines. Rising energy costs provided the platform for wage increase demands.

Average Hourly earning of production and non-supervisory employees


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The employment scene in 2014 is vastly different. China has suppressed incomes in the manufacturing sector. Technology has driven workplace efficiencies. Union membership is at record lows. The social security safety net — unemployment benefits, disability payment, food stamps — has enabled more people to opt out of work force engagement. This explains why the right hand side of the FRED chart shows post-GFC wages growth tanking. Globalisation means we are competing against the labour costs from emerging and emerged economies of China, India, South Korea, and soon to be, Africa. The prospect of a 1970s style wages outbreak against these very powerful forces is unlikely.

Finally, although interest rates were high in the 1970s household balance sheets were still in the debt expansion phase. The following chart shows US household debt expanded threefold during the 1970s, from around $440 billion in 1970 to $1.3 trillion in 1980.


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Since 2008, US household debt accumulation has taken a breather. The likelihood of a 300% expansion in household debt from current levels is remote. After four decades of heaping loan upon loan, there’s debt fatigue out there — even with the lowest interest rates in history.

The 1970s has been defined as a period of stagflation (high inflation with moderate growth). We do not appear to have either of these components in today’s economy. And as outlined above, we are unlikely to witness them.

When the artificial US share market bubble pops and GFC MkII unleashes its fury, the era it’ll most likely resemble is that of the 1930s.

Stay tuned for the latest CPI numbers and listen for more talk of subdued trading conditions making the road back to recovery more difficult than expected.

The Great Credit Contraction is an unrelenting force the authorities are struggling to contain and outmaneuver. Nearly every trick in the central bankers playbook has been thrown at this vice like force, yet nothing has permanently altered the low inflation and possible deflationary course we are on.

The only inflation out there is in the egos of central bankers and IMF officials who think they can control markets. When the secular bear market wakes from its slumber, it is certain to deflate these as well.

Vern Gowdie
Editor, Gowdie Family Wealth

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Vern Gowdie 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 five financial planning firms in Australia. He 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. Vern is is Founder and Chairman of the Gowdie Family Wealth advisory service, a monthly newsletter with a clear aim: to help you build and protect wealth for future generations of your family. He is also editor of The Gowdie Letter, which aims to help you protect and grow your wealth during the great credit contraction. To have Vern’s enlightening market critique and commentary delivered straight to your inbox, take out a free subscription to Markets and Money here. Official websites and financial eletters Vern writes for:

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