The US is staring at deflation

Aug 4, 2010

Ouzilly, France,

We left off yesterday wondering what stock market investors were thinking. They bought stocks heavily on Monday. Then, yesterday, they sold them a bit - the Dow fell 38 points.

Yesterday was largely uneventful. Gold rose a dollar. Oil climbed to $82.

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Maybe stock market investors are not really expecting to get rich. Maybe they're trying to avoid getting poor. They may figure that the real risk is being in cash....not in stocks.

If so...they may have a point.

Here's the low-down...

As near as we can tell, the Japanese-style correction is still underway. Consumers are careful about spending because they fear they might not have jobs. Employers are careful about hiring because they fear they might not have revenue. And banks are careful about lending because 1) few people want to borrow and 2) the banks figure they may need the money themselves.

Meanwhile, Ben Bernanke has staked his entire reputation on being able to AVOID a Japanese-style slump. He gave a famous speech about it back on the 21st of November 2002. He called it "Deflation: Making Sure it Doesn't Happen Here."

Well, that was when the inflation rate was not far from the Fed's 2% target. What's happened since? The consumer price inflation level - as measured by the government - has now dropped down to 0.5%. And many economists think it will go negative soon.

Hmmm.... This leaves Mr. Bernanke in a tight spot. It looks like deflation IS happening here. And it is happening AFTER Ben Bernanke has already used most of his tricks to stop it. The Fed is lending money at 0.25% interest - effectively zero. What's it going to do next? Pay you to take the money?

If Bernanke allows deflation to happen...and persist...he will have Congress on his back. The Fed is supposed to be independent. But every Fed member knows which side his bread is buttered on. And no one doubts where the butter comes from -- the US Congress and the administration. And everyone also knows that there will be mid-term elections this year.

As it stands, the voters are not too happy. They've seen the banks get bailed out. They've watched Goldman's boys make their millions. And they've begun to wonder whose interests their elected representatives are really serving - the voters who sent them to Washington? Or the special interests who write big campaign checks? (Goldman gave millions to the Obama of the best investments it ever made...)

Unfortunately for democracy, the poor voter has no idea of what is going on or why. If he has a job and his house is rising in price, he'll likely vote for the clowns already in Washington. If not, he'll want new clowns.

And right now, his house is likely to be underwater...and probably sinking. As for his job, he's lucky to have one.

Ben Bernanke must surely feel the pressure to "DO SOMETHING," right?

Not only that, his reputation is at stake too. What did he say in that remarkable 2002 speech? Oh yes, "that under a paper money system, a determined government can always generate higher spending and hence positive inflation."

Well, maybe. But so far, it is looking as though it may not be as easy as the younger Mr. Bernanke thought. We have a paper money system, no doubt about that. We also have a Fed that is determined to keep inflation positive. But we also have inflation that is becoming less positive every day...and may turn negative soon.

*** Remember our discussion of prices yesterday? Here at the Daily Reckoning, we have nothing against higher prices...and nothing against lower prices. It's dishonest, misleading, and treacherously false prices that we don't like. They send the wrong information. They may tell us that an item is plentiful, for example, when it is actually in short supply. They may cause us to invest our money in the belief that profit margins are increasing when they are actually shrinking. They may also induce us to expand production, when the world already has far too much of what we have to offer.

And unfortunately for the market system, we live in a world of phony prices. Nobody knows what anything is really worth... Let's take a simple concept like consumer price levels, generally. According to the feds' calculation they're barely rising at all. But if you computed them the same way the Europeans do, you'd find the US price level moving up at 3.5% per year.

So, then you'd have to wonder whether Bernanke and company should be concerned at all. If it's inflation they want, inflation is what they've got. Maybe. We don't know. We can't trust prices...or the calculation of price levels.

But the Bernanke team probably has to trust its own numbers. After all, if you can't trust numbers you twisted yourself, what is the world coming to?

Besides, whether the inflation rate is 0.5% or 3.5% hardly matters. People don't have jobs. They don't have incomes. They don't have much desire to vote for sitting politicians. And Ben Bernanke is going to lose his reputation - such as it is - if he allows this Japanese-like slump to continue.

So, what's he going to do. He has to 'Do Something'...but what? Well, there aren't many choices. About the only thing he has left is 'quantitative easing.' Yes, maybe stock market investors are right. Maybe they don't really think stock prices are going to rise. Maybe what they're really worried about is that cash will turn out to be a bigger trap that stocks. After all, if there is one thing a central bank ought to be able to do - if it puts its mind to it - is create 'positive' inflation. And it looks as though the Bernanke Fed will go all out to do it.

The Fed's Open Market Committee meets next week. Most likely, they're going to threaten to buy more treasury bonds. That's the way they hope to get more dollars in circulation and raise consumer prices - thus encouraging both "positive" inflation and consumer spending. If that doesn't work, they'll have to resort to even more radical solutions - such as dropping money from helicopters.

They'll keep at it, most likely, until they get the job done. Whether that will take 6 months or 6 years - we don't know.

In the meantime, the sensible investor may figure he'd rather be in, say, Exxon or Intel or Johnson and Johnson rather than in the US dollar. Many of the blue chips are cheap. They will probably get cheaper. But then, once the Bernanke inflation machine begins to get some traction, they will probably be a much better place for you money than cash.

Bill Bonner is the President & Founder of Agora Inc, an international publisher of financial and special interest books and newsletters.

Disclaimer: The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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