Brian Yelvington, fixed income strategist at Knight Research, is concerned about the potential for deflation in the US. As he put it in a note published on Friday:
Data observations and central bank concerns have led us to believe that we might not just be in a deleveraging process, but a deflationary process as well.
The process of cash builds, financial austerity, and decreased demand are a perfect recipe for a deflationary process.
The Fed will have some tough choices as fiscal austerity might pit the Central Bank’s goals against those of the Federal Government’s.
Yelvington is quick to point out that deflation is “not a 100% certainty”; nonetheless, he feels that the “stage might well be set for a deflationary process.”
As he argued (emphasis FT Alphaville’s):
A deflationary process looks much the same at the outset as an inflationary process brought about by policymakers. The difference is that a deflationary process’ lack of demand thwarts the central banks’ primary policy tools.
…
As any Keynesian will tell you, the problem with capitalist societies are the cycles that occur. No one really minds the uptrend, but the downtrend is a key criticism of capitalism in general. In our latest economic cycle, we have argued that a credit bubble resulted in asset price inflation, and then subsequent deleveraging. We further argue that this process of cash builds, and then financial austerity can result in decreased demand — the perfect recipe for a deflationary process.
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The problem with this flow of cheap money is that it has a negative impact on the real economy after a bubble pops. Cash hoarding quickly reduces the velocity of money (i.e. the speed at which money is recycled through the real economy) since the preference to save outstrips the preference to spend and lowers demand. In a deflationary spiral, a combination of excess goods & services, a decline in the velocity of money and cash hoarding all combine to render useless further monetary policy efforts to spur on demand.
Got that? No? Here’s the argument, illustrated (click to enlarge):
The charts above show several of the deflationary elements worrying Yelvington: M2 velocity has decreased 8.8 per cent since the onset of the crisis, and the savings rate is once again ticking upward. At the same time, banks’ commercial lending and leasing “hit new lows on an almost weekly basis,” according to the Knight strategist.
Moreover:
Cuts in fiscal spending contribute to deflation by reducing demand to counter budget deficits (the Keynesian Paradox). Pressures are on for governments worldwide to cut spending to avoid overleveraging. Within the US, this is especially true at the state and municipal levels.
And as Yelvington noted, some members of the Federal Open Market Committee are themselves concerned about the risk of the deflation, as the minutes of the most recent meeting show.
The debate continues.
Related links:
On the edge of a deflationary precipice… – FT Alphaville
Notes from the deflationary quicksand – FT Alphaville
[Bob and Kevin on AV] Capital Stock is too high – deflation ahead? – FT Alphaville
Morgan Stanley mulls ‘debtflation’ – FT Alphaville