Fall in Commodity Prices Will Reduce Inflationary Forces

Now to the big subject of the day. Inflation. You’d think evidence of even bigger deficits in the U.S. is clearly inflationary. But not everyone thinks so. The new prophet of doom, Dr. Nouriel Roubini, says at least four factors are setting up what he calls “Stag Deflation” (as opposed to the stagflation of the 1970s, where you had no growth and rising prices).

Roubini’s four forces of Stag Deflation are: a slack in goods markets, a ‘recoupling’ of the rest of the world with the U.S. recession, a slack in labour markets, and a sharp fall in commodity prices. These factors would, “reduce inflationary forces and lead to deflationary forces in the global economy,” he writes in an article in Forbes.

“Aggregate demand is now collapsing in the U.S. and advanced economies, and sharply decelerating in emerging markets,” he writes. “There is a huge excess capacity for the production of manufactured goods in the global economy, as the massive, and excessive, capital expenditure in China and Asia (Chinese real investment is now close to 50% of gross domestic product) has created an excess supply of goods that will remain unsold as global aggregate demand falls.”

You’ll have to bear with us a moment, dear reader, as we work out what this means. First, though, is Roubini right? Well, he’s certainly right that there’s a big fall in aggregate demand in the U.S. It’s obviously passing through to manufacturers and commodity producers (China and Australia). But won’t monetary and fiscal policy designed to combat deflation…you know…cause inflation?

Roubini takes that point head on. He says the liquidity measures taken on by the Fed to get credit flowing and recapitalise U.S. banks are not all inflationary. He says once liquidity is restored to the credit markets (banks begin lending, money market funds starts buying commercial paper again) the central bank can simply “mop up” excess liquidity before it seeps into the real economy to cause inflationary damage.

And what about the tendency of governments to fight debt deflation with inflation? Not a worry either, says Roubini. He says that most of the household debt in the U.S. is short-term variable rate debt that’s resistant to being “inflated away” by cranking up the printing presses. Is he right?

Well it all comes down to how much money the Fed and the Treasury are going to need before the recapitalisation of the American financial sector is over and how they plan to raise that money. The banks will probably need more capital than anyone’s expecting. And there are other landmines down the road.

In short, the Treasury and Fed will need more money. Roubini assumes the Fed can simply remove the lending back stops it’s provided once the market returns to normal. But what if it doesn’t and the Fed can’t? What happens next?

Governments get money three ways, taxing, borrowing, or printing it. You can rule out an increase in taxes large enough to fund the Fed’s needs. It won’t happen with an economy already contracting. Even if Obama raises taxes when he’s elected, it won’t be enough to meet the Fed’s immediate needs. That leaves borrowing and printing.

On September 17th, the U.S. Treasury announced a Supplementary Financing Program. It initiated the program at the request of the Federal Reserve. The Fed needed the Treasury to go out and sell more bonds so the Fed would have money to fund its various lending back stops. The Fed was nearly broke.

Since then, thanks largely to the huge flight to Treasuries sparked by deleveraging and the collapse of the dollar/yen carry trades, the Supplementary Financing Account set up by the Treasury has fed the Fed nearly $560 billion. Some of that may have gone to AIG. Some of it to Fannie and Freddie. Some may go to Chrysler, Ford, and GM. Who knows?

But the main point, from Roubini’s perspective, is that as long as the Fed can finance its lending with new borrowing from the Treasury, it’s not inflationary. The only thing that would make this armada of liquidity measures and loan guarantees and bailouts truly inflationary is if the Treasury couldn’t go out and sell new bonds to gullible foreign investors. As long as the Treasury can sell more bonds, the Fed can make more loans without sparking inflation.

But if we’re right and the bond bubble began bursting in late October, well then the Treasury’s line of credit with global savers is nearing an end. Global creditors will be reluctant to finance American deficits. In order to borrow, the Treasury is going to have pay much higher rates of interest to reflect the credit risk the U.S. government has become.

Trouble is, the U.S. can’t afford to borrow at higher interest rates right now. So that leaves the option Roubini thinks is least likely: printing money. The fancy term for it would be “monetising the debt.”

That means the Fed would buy public debt issued by the U.S. Treasury with freshly printed money. And THAT, we reckon, is super inflationary. Any time you start rolling out new greenbacks to pay for new bonds which you give to corporations in exchange for their garbage securities, you’re going to damage the confidence people have in the currency (the U.S. dollar).

But then, Roubini has been right about an awful lot lately. It’s possible the Fed will not be forced to monetise the debt. It’s possible that a global contraction is truly deflationary. We don’t really know. But we’re not nearly as sanguine as Roubini that you can expand the monetary base as quickly as the Fed has and be confident it can all be mopped up later without causing inflation. Try getting motor oil out of an engine and back into the bottle.

Dan Denning
for Markets and Money

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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6 Comments on "Fall in Commodity Prices Will Reduce Inflationary Forces"

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ralph hill

“But then, Roubini has been right about an awful lot lately. It’s possible the Fed will not be forced to monetise the debt.”

Do pigs fly ?

Do politicians spend too much ?

Clearly, the only way out of the crack-up is to replace politicians with flying pigs !

Or put it this way, the rascals in DC and their spending habits would put the proverbial ‘drunken sailor’ to shame. Does anyone half way sober or partially lucid really expect either REFORM or HONESTY from a bunch of windbags with that track record?

Greg Atkinson
I have sort of just given up trying to make any guesstimates about the short to medium term economic outlook at the moment. Now we have governments in semi-panic mode, we have to be wary of the next “bright idea” and what unintended consequences it will have. But with so much money being pumped into the system I do think we wake up with a nice inflation induced hangover at some point. As for Roubini, well he is certainly having his 15 minutes of fame! Before this market debacle he was a bit of an unknown and I just hope… Read more »
I think that what Professor Roubini says can possibly come true, but only if the monetary authories: central banks, banks, governments & treasuries; allow it to happen, however, to take the other side to his arguments, one can also say that: 1) the slack in the goods market can be partially made up by the major emerging economies: China, Brazil, Russia, India, thus allowing a reduced amount of growth in these economies, but certainly not a recession. Is China’s 9% reduced growth rate classified as a recession? Certainly not. If certain countries can continue to grow, albeit at a much… Read more »

Nostradamus was right about a lot of things too. But he was also wrong about a lot of things


The last few years has seen the central banks trying to avoid a reccession at any cost by keeping interest rates low. This has only served to inflate the various “bubbles” further and intensifying the unavoidable crash.

Given their track record so far I think the next move will be to monetize the debt. If that happens it will result in the next generation of taxpayers being thrown into a form of monetary serfdom.

Very Interested

The “Prophet of Doom” business is booming! How can I get some of that action?

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