The Deflation Fighters!


Well, that didn’t last long…but then again you shouldn’t have expected it to. US markets were down overnight as yesterday’s Fed induced rally petered out.

As I mentioned yesterday, a lot of traders were taken by surprise by the Fed’s interest rate rhetoric. This led to a lot of knee jerk buying and selling. Notably, the US dollar had its biggest fall in years and most non-US dollar assets rallied.

But that trade reversed somewhat overnight, with oil back down 2.5% and the Aussie dollar down heavily too. On a positive note, gold held its gains. With the Aussie battler retreating, Aussie dollar gold put in a good performance.

Does this mean the correction in Aussie dollar gold is over? The chart below looks positive at least. After falling as low as AU$1,475, the price closed at $1,530 overnight. If it is bottoming here, it lends weight to my theory that gold is in the early stages of a new bull market, one that ultimately kicked off in November 2014.


Click to enlarge

Time will tell. But so far, so good.

On another note, I gave a brief presentation earlier this week. I titled it ‘Market Bullish, Economy Rubbish’.

It was an attempt to explain that the market is going up not because the economy is strong, but because interest rates are falling and investors are piling into the stock market to try and get a better return on their capital.

If you go one step further, interest rates are low because central banks around the world fear the threat of deflation, which is a general fall in the price level of consumer goods and services.

Their reasoning is that if deflation takes hold, people will delay spending money and already weak demand will become weaker.

I’ve long said this is an idiotic argument. Demand is weak around the world because we’re labouring under the effects of record debt levels. Debt, in its simplest form, is just consumption brought forward.

So high debts levels are a sign that future demand has been brought into the present…and the past. There’s not a great deal more excess consumption to wring out of the system.

But this doesn’t stop central banks trying to create it. And no matter what the evidence, they’ll keep trying. And the evidence is in…

I’ve spent the morning looking through the Bank for International Settlements’ (BIS) latest quarterly report. BIS is referred to as the central banks’ central bank. The irony of that title is that it often puts out the best research of any central bank and is openly critical of the effects of easy money.

I found something in the report that completely blows the ‘deflation’ argument out of the water. Not that anyone will take notice of it.

Just so you’ve got it straight, central banks constantly bang on about the threat of deflation and its negative effect on economic growth when justifying interest rate cuts.

So the BIS did a study on the relationship between changes in prices of consumer goods and services (which measure the rate of inflation or deflation) and their effect on economic growth. It covered the period from 1870 to 2013. Here’s what they found (my emphasis):

On balance, the relationship between changes in the consumer price index and output growth is episodic and weak. Higher inflation is consistently associated with higher growth only in the second half of the interwar period, which is dominated by the Great Depression – the coefficients are positive and statistically significant. At other times, no statistically significant link is apparent except in the postwar era, in which higher inflation actually coincides with lower output growth, with no significant change in the correlation during deflations. In other words, the only sign that price deflation coincides with lower output growth comes from the Great Depression and its immediate aftermath.

But, but…deflation is bad! We must fight it!

That’s true to a point. The BIS study points out that deflation does have a negative impact on economic growth — deflation of equity and property prices…

By contrast, output growth and asset price changes are significantly positively correlated over the full sample and in most subsamples

‘The relative performance of equity and property prices varies across subperiods, but they all have a positive relationship with growth in the postwar era. That of property prices is especially sizeable during this period. Moreover, the positive and statistically significant coefficients on the interaction terms suggest that, postwar, the link with asset price declines is stronger than the link with increases. In particular, the coefficient of the change in property prices more than doubles when these prices decline.’

Put simply, when asset prices suffer large declines, the effect on economic output is strong. When prices of goods and services decline, the effect on economic output is negligible.

But that doesn’t stop central banks cutting rates with ‘deflation’ as the justification. Well, as long we keep swallowing their lies, they will keep on serving them up.

The BIS report also helpfully pointed out all of the central banks that eased monetary policy over the past few months. Here they are:

Peru (three times)
Switzerland (two times)
India (two times)
Denmark (four times)
Turkey (two times)
European Central Bank
China (two times)

That sure is a lot of deflation fighting!

Until next week…

Greg Canavan,
for The Daily Reckoning Australia

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Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.

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2 Comments on "The Deflation Fighters!"

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slewie the pi-rat
slewie the pi-rat
1 year 7 months ago
“Debt, in its simplest form, is just consumption brought forward.” whether that is the simplest form, or not, is it the best definition for thinking through this? after all, we are talking about what those huge debt-numbers MEAN. “One differentiator of Fekete’s economics is in his concept of the loan. Others think of it as an exchange of present goods for future goods, but he had an insight. The essential characteristic of a loan is that it involves an exchange of wealth and income. … … We can think of the loan as the purchase of an income stream. Cash… Read more »
David Bruce
David Bruce
1 year 7 months ago

Insurance Line revised my insurance premium today, with an additional 5% cover to help keep up with INFLATION! It is based on their calculation of the Australian Consumer Price Index! Hmmmm…

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