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, 29 May, 2014

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

click to enlarge


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.

click to enlarge

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

click to enlarge

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.

click to enlarge

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

Vern Gowdie

Vern Gowdie has been involved in financial planning in Australia 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 magazine as one of the top 5 financial planning firms in Australia. He is a feature contributing editor to The Daily Reckoning and is Founder and Chairman of the Gowdie Family Wealth advisory service and editor of the Gowdie Letter To follow Vern's financial world view more closely you can you can subscribe to The Daily Reckoning for free here.

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3 Comments on "Deflating the Inflation Story"

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slewie the pi-rat
slewie the pi-rat
2 years 3 months ago
“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.” the “GDP deflator” ended up at -1.9%, as US inflation numbers apparently spiked in Q1. after all the data were in and final, nominal GDP was at -1.0% with the deflator added, the number came to -2.9%. both numbers were surprising in that “economists” did not “expect” them in their “consensus”. slewienomics, knowing the con-men and women involved and the political aspects of the fiat-gone-wild ACCOUNTING games, theorized as follows: once The Powers… Read more »
2 years 3 months ago
According to an oil production graph that includes US shale production form the I.E.A it lookslike the US will not be an oil exporter. The same oil production graph shows the Middle East facing problems at the same time. The US government is however allowing oil companies to export crude oil and kerogen to refineries overseas where the wages are lower than in America to have the oil refined, but this is in reality an example of the stingy rich wanting to go for the cheap wage labour rather than an actual export as the refined fuels are returned to… Read more »
2 years 3 months ago

Actually world petroleum production hit its peak around the year 2000 and has been declining ever since. Soon we’ll slide off “the shoulder” and the decline in production will become very steep. Many places in the world are going to unhinge. There can hardly be economic growth in places undergoing active hot wars. Dead people are also lousy consumers.

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