The deflation-inflation two-step: Too complex for deflationsts to grasp?/margotbworldnews.

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Ka-Poom Theory deflation - inflation two step: Too complex for deflationsts to grasp? The deflation-inflation two-step: Too complex for deflationsts to grasp? By mistaking the short term for the long term, they are missing the trade of the century by Eric Janszen Over 100 books, papers, and original analysis went into developing and refining Ka-Poom Theory over the years, and model that explains how, following the collapse of the credit bubble, the US economy will experience a short (six month to one year) period of deflation that we call disinflation, such as we are experiencing today, followed by a major inflation induced by monetary and fiscal policy and the actions of US trade partners in response to that inflation. It appears that the deflationista camp is incapable of comprehending a model, and the events that it forecasts, that lays out a two step process. For some reason they cannot grasp the fact governments will respond to disinflation with inflation, that the impact of those interventions is not instantaneous, and that markets historically are not very good at foreseeing the change in inflationary conditions in either direction. Ka-Poom Theory in 1999, the original disinflation/reflation theory developed nearly ten years ago, does not merely forecast a period of deflation or disinflation that is inevitable after the massive credit bubble popped. A child could do that. We call it "Ka" as the first step in the two step process outlined by Ka-Poom Theory. The difficult part is forecasting what comes after the disinflation phase. Does the Fed sit back and do nothing while the debt deflation runs out of cotnrol? Does the Fed have a choice, or does it become impotent, overwhelmed by the rate of debt defaults and money destruction? The deflationistas apparently think what comes after post-bubble deflation is more deflation, as occurred in the early 1930s in the US but nowhere else ever since. It has not occurred to the deflationists why no similar period of deflation has ever occurred since the 1930s, or when they do confront the question they explain that the debt is really, really, really big debt this time, bigger than the Fed. Or that differences between the kind of money that the Fed prints versus the kind of money that the endogenous credit markets create when money is loaned into being by businesses and consumers means the Fed cannot impact the latter. As we explain that in The truth about deflation, the reason no deflation spiral has occurred in any nation since the one instance in the US in the 1930s is because since then no nation has chosen to remain on the gold standard through a debt deflation. Needless to say, the US is not on a gold standard today. What governments do when confronted with a deflation spiral is take measures to increase the money supply to induce inflation. If they succeed and money aggregates are increased, over time inflation will follow. Money first, inflation second One of the better papers on this topic is No money, no inflationthe role of money in the economy by Mervyn King, Deputy Governor, Bank of England. It was presented to the Festschrift in honour of Professor Charles Goodhart held at the Bank of England on 15 November 2001. Most people think economics is the study of money. But there is a paradox in the role of money in economic policy. It is this: that as price stability has become recognised as the central objective of central banks, the attention actually paid by central banks to money has declined.
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The deflation-inflation two-step: Too complex for deflationsts to grasp?/margotbworldnews.com

It is no accident that during the Great Inflation of the post-war period money, as a causal factor for inflation, was ignored by much of the economic establishment. In the late 1970s, the counter-revolution in economicsthe idea that in the long run money affected the price level and not the level of outputreturned money to centre stage in economic policy. As Milton Friedman put it, inflation is always and everywhere a monetary phenomenon. If inflation was a monetary phenomenon, then controlling the supply of money was the route to low inflation. Monetary aggregates became central to the conduct of monetary policy. But the passage to low inflation proved painful. Nor did the monetary aggregates respond kindly to the attempts by central banks to control them. As the governor of the Bank of Canada at the time, Gerald Bouey, remarked, we didnt abandon the monetary aggregates, they abandoned us. So, as central banks became more and more focused on achieving price stability, less and less attention was paid to movements in money. Indeed, the decline of interest in money appeared to go hand in hand with success in maintaining low and stable inflation. How do we explain the apparent contradiction that the acceptance of the idea that inflation is a monetary phenomenon has been accompanied by the lack of any reference to money in the conduct of monetary policy during its most successful period? That paradox is the subject of my talk. This paper contributed three concepts to Ka-Poom Theory that deflationistas should think very carefully about. Read the paper and its conclusions are inescapable. One, if "No money, no inflation" then if "Money, inflation." Two, money first, inflation second with long and unpredictable time lags. Three, the money markets always get it wrong; inflation expectations are sticky following periods of deflation and sticky following periods of inflation. The big money to be made in our fiat money era is in betting that the bond market is getting it wrong rather than assuming that a market that is forecasting future inflation or deflation is getting it right. When governments are inflating, the bond markets tend to be right short term, wrong long term. That being the case, this may be the trade of the century because the bond markets are pricing corporates, treasury bonds, and TIPS as if it's 1931 and the US and the world was on the gold standard, or it's 1974 and recession is about to take inflation down for the count. Mike Shedlock does a good job of describing the phenomena here recently in Industrial Bond Yields Strongly Support Deflation Thesis. The error is mistaking short term for long term inflation pricing phenomena. The one step deflationists miss is the all important second step in the two-step Ka-Poom deflation/inflation process. King demonstrates the long term correlation between money and inflation in the UK going back to 1885.

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The deflation-inflation two-step: Too complex for deflationsts to grasp?/margotbworldnews.com

Next he shows the correlation between money and inflation in specific national cases where money aggregates grow, and offers several examples. One inflation case is Israel 1984 to 1987 shown below. This is more or less the level of inflation that iTulip expects during the inflation phase, not exceeding 30% or so in peak years.

King presents Japan 1990 to 2001 as an example of a country that did not expand money aggregates and experienced modest deflation but nothing like what occurred in the US in the 1930s.

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The heart of King's argument, backed by solid research, is: [The charts show ] the correlation between the growth of the monetary base and inflation over different time horizons for a large sample of 116 countries. Countries with faster growth rates of money experience higher inflation. It is clear from [the charts] that the correlation between money growth and inflation is greater the longer is the time horizon over which both are measured. In the short run, the correlation between monetary growth and inflation is much less apparent. King backs up this assertion with solid analysis. Here are a few relevant charts.

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The deflation-inflation two-step: Too complex for deflationsts to grasp?/margotbworldnews.com

x Is the US Japan 1990 or Israel 1984? If past growth in money aggregates in the US spells higher inflation in five to ten years, then why are the bond markets betting on continued deflation? The TIPS market is signaling sub 1% annual inflation going out five years.

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The deflation-inflation two-step: Too complex for deflationsts to grasp?/margotbworldnews.com

We accept the conclusion of King's research that inflation will eventually follow from money growth. Let's turn our attention to money aggregates here in the US. Unfortunately, the Fed in 2006 removed one of the main tools available to measure broad money, M3. The conspiracy minded might find the timing of the Fed's decision to omit this data as extraordinarily convenient. We think it is intended to keep the bond market guessing while a range of new policy tools are tried to combat debt deflation.

The Economist the following assessment.

in Inflation or deflation? weighed in July this year with

What makes the situation so obscure is the leads and lags in the economic data. The global economy is still absorbing the impact of the rise in oil above $100 a barrel, let alone its subsequent gains. And the Federal Reserve's long series of rate cuts are still working their way through the system. Then there is the American tax rebate, still sitting in many consumers' bank accounts. That suggests both the inflationists and the deflationists are going to have plenty of ammunition over the next few months. In turn, that will make it hard for investors to make a decisive choice, and that means the volatility in financial markets will continue over the next few months. Long term, the inflationists look to have a better case. The world has paper money and the central bank that runs its reserve currency (the dollar) has repeatedly erred on the side of loose monetary policy, for economic and financial reasons. Emerging markets, nowadays the drivers of global growth, have loose monetary policies in aggregate. Treasury bonds may occasionally benefit from flights to safety over the next few months, particularly as the banking sector continues to struggle. But it is hard to believe that yields of 4% or so will look good value in five years' time. Money at Zero Maturity remains, but we worry that it does not include all of the money that was in M3, and through its creativity entirely new M's have been invented -- call them M4, M5, M6 -- that we cannot see because they are nor reported by the Fed. Still, even MZM shows 17% growth since the beginning of the crisis in Q1 2007.

Has the bond market gotten it wrong before? Short term no, long term yes. This makes for interesting trading opportunities if you can figure out what the bond markets don't know before they do.
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The current parting of company between corporate bonds and Treasury Bills reminds us of the 1973-74 recession. That disconnect was resolved when inflation fell at the end of the recession along with treasury and corporate bond yields; bond prices increased. That appears to be what the bond market is saying today and in spades. As we know now, that didn't last long: the US had a lot of debt to inflate away, and so it did between 1975 and 1980. A few years later inflation was in the double digits. While the bond markets were "right" in the short run they were "wrong" in the long run. A great trade then was BAA bonds purchased at 11% in 1974 during the worst of the recession when default rates were highest and inflation expectations lowest, then sold in 1977 when these bonds increased in value to 8% before inflation picked up again, then bought again at 17% in 1983 and held to maturity. High corporate yields and treasury bonds in 1974 and 1983 signaling high default and inflation risk. Will we see a trade like that again? There are two major differences between this period and that one. 1. T-Bills were trading near 9% versus 1% today. Deflationists interpret this to mean that there is no inflation risk priced into corp. bonds. But how much lower can T-Bills go before the Fed has to shock the system, if it hasn't already? 2. Year over year inflation volatility was low then but has been the highest in history since 2001. Given the lags between money growth, the stickiness of inflation expectations in bond markets, and the Fed's lack of money aggregate transparency while experimenting with the money markets, and inflation volatility scrambling inflation signals, anyone trying to forecast inflation by looking at bond yields and spreads or commodity prices under these unusual circumstances is like a pilot flying through a storm and depending on the airspeed indicator to measure ground speed and calculate future distance. The Fed won't give us the complete picture of our money supply deflationary or inflationary headwinds. The inflation data that we do have, a lagging indicator of past money growth as King's research shows, are all
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over the place. Apparently the bond markets think deflationary head winds are so strong that the plane is flying backwards and will continue to do so for years. Will we land in the land of oz? Will we land at all or go up in a ball of deflationary fire? In this crazy environment what is likely to happen, as has happened in the past, is that the bond market will figure out all at once that pricing signals it mistook for a long term deflationary headwind were actually the deflationary down draft of a collapsing asset bubble followed by a powerful inflationary tailwind that started off as Fed induced money growth years before. Anyone caught on the wrong side of the market when that epiphany finally occurs will suffer the consequences. The deflationistas can take this as their final warning from the inventors of the original deflation/inflation cycle theory. Timing? When will bond markets become unstuck? Impossible. You are betting on second order effects -- the bond market's interpretation of inflation resulting from past money growth, mostly hidden -- and network effects -- bond market participants' interpretations of each other's behavior. Even worse from a timing perspective, if the Fed takes drastic steps to signal an inflation change in the wind to halt deflation, it is not going to issue a polite warning that permits a quick trade out of portfolios positioned for an ongoing deflation. The resulting bond market reversal, as occurred in the early 1930s years before the dollar depreciation and reflation, can be tough on unhedged deflation positioned portfolios. Samuel Brittan, writing for the Financial Times 28/03/03 said in an article How to escape the liquidity trap:

A popular course, frequently advocated for Japan, is preannounced devaluation. This would both raise price expectation and provide a direct stimulus to exports. The biggest problem with this remedy is that it would be quite inappropriate if the threat of slump were international rather than confined to one country.
Brittan doesn't mean the US, he means Germany or Japan or any country except the US. A future dollar devaluation will not be the first time the US took "inappropriate" action with its currency to save its own skin, such as in 1934, 1971, twice in 1973, and a stealth devaluation from 2002 to 2008. Anyone who does not hold inflation hedges is betting that the US government won't behave in the future according to an established pattern of policy and behavior. That strikes us as unwise. Flawed Framework The framework of the inflation versus deflation debate is flawed from our perspective. It comes down to two camps, the inflationists like Marc Faber and Jim Rogers who claim that the US will some day be unable to sell more bonds and will eventually be forced to print money to cover fiscal expenses without issuing new debt. These are the Wiemar inflationists. The deflationist camp is represented best by Roubini who asserts that the US government cannot risk letting the inflation genie out of the bottle via unsterilized money injections and, anyway, such a policy, besides wrecking the reputation of the Fed, will not work to reduce overall debt levels because too much US debt is short term and rates will rise to cause repayment of aggregate debt to skyrocket. This deflation/inflation framework is summarized in JP Morgan forecast: strong global recession, deflation. Ka-Poom Theory since 1999 occupies a position outside this framework. It asserts that all of the money that the US needs to create monetary inflation that deflates both its external debts and domestic private debts already resides outside the US in the form of more than $13 trillion in gross external debt to the tune of 95% of GDP. Most of that debt is in the form of US treasury bonds. All the US has to do to devalue the dollar is
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induce its trade partners to sell, perhaps by indicating an intention to monetize debt wothout actually doing so, causing US creditors to sell some dollar denominated securities for assets not priced in dollars, resulting in an increase in the global supply of dollars. The effect is the same as the US printing money but without a corresponding issuance of new debt and the attendant risk of hyperinflation that Roubini refers to. As the US learned years ago, why devalue your currency when you can get your creditors to do it for you? Nothing halts deflation like the inflation signals that issue forth from rising import prices. Has everyone already forgotten 2002 to 2006 when oil prices increased 300%? Since most US debt is held by central banks, the selling is unlikely to be disorderly. Why risk a runaway inflation if you can turn a knob and order a few percentage points of deflation fighting currency depreciation? Between the inflation that is already baked into the cake by increases in monetary aggregates over the past year and the opportunity for the US to enlist its trade partners in the task of sending the dollar back down and inflation up, the second step of the two step Ka-Poom Theory process hovers somewhere over the horizon. PIMCO recently got back into TIPS. Better early than late. Depression with inflation? How? This is by far the most unintuitive part of our argument. Our ongoing unemployment analysis Unemployment by industry: Recession or depression? is pointing us to depression-like joblessness over the next couple of years. Where will the money come from to create inflation if so many are unemployed, borrowing is depressed, and banks are hanging on to the capital lent to them by the Fed? The answer goes back to research that produced

the graphic to the left. It is the reason why a government will engage in currency devaluations, if it thinks it can get away with it. From 2002 to 2008 when the dollar declined by 37% and the CRB Raw Industrials Index rose from a 2001 recession low of 225 to a 2008 peak of 525. Even if 50% of this increase was due to demand, 50% was still due to dollar depreciation. That is a powerful anti-deflation force that also allowed the US to boost exports. In countries where currency depreciation runs out of control, and the feedback loops indicated in the chart are not interrupted by a concerted policy response that includes interest rate hikes, the inflationary impact is devastating, even as economic activity and output collapses. We don't expect that to happen to the US because its debts are issued in its own currency. iTulip Select: The Investment Thesis for the Next Cycle __________________________________________________ To receive the iTulip Newsletter iTulip Alerts , Join our FREE Email Mailing List or

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