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According to some analysts a sharp decline in major
commodity price indexes has raised the spectre of deflation. The Journal
of Commerce commodity price index (JCOM) fell by 8.5 per cent in May from
April while the commodity price index CRB fell by 8.2 per cent during that
period. Also the growth momentum of these indexes has plunged in May. The
yearly rate of growth of the JCOM index fell to 47.9 per cent from 77 per
cent in April while the yearly rate of growth of the CRB index plunged to 0.7
per cent from 24.9 per cent.
Now if some other price indexes were to come under
pressure would it then imply that the economy has fallen into deflationary
territory? To provide an answer to this question we need to define what
deflation is all about. Contrary to popular thinking deflation is not about a
general decline in prices as such but about a decline in the money supply.
Note that this is based on the same principle that inflation is not about a
general increase in prices but rather about increases in money supply.
Since a price of a good is the amount of money paid
per unit of the good obviously within the context of all other things being
equal the prices of goods in general will go up over time with increases in
money supply and fall with decreases in money supply. To establish then
whether we are in deflation we need to find out what the money supply is
doing. The latest data for our monetary measure AMS shows that the yearly
rate of growth stood at 4.7 per cent in May against 1 per cent in January. A
positive figure for the rate of growth in money supply implies that at the
moment inflation is still in force.
Note though that during October to December last
year we actually had deflation. The yearly rate of growth of AMS stood at
minus 6 per cent in October, minus 10 per cent in November and minus 7.1 per
cent in December.
Normally the main driving force in the expansion of
money supply is the central bank’s loose monetary policy. By means of
monetary pumping the central bank injects money into the banking system. This
money in turn is amplified by commercial banks lending through so called
fractional reserve banking. Currently however, there seems to be a breakdown
between the Fed’s pumping and commercial banks’ lending activity.
Despite all the massive monetary injections by the
Fed commercial banks have chosen to sit on the pile of pumped cash rather
than lend it out. The level of excess reserves held by commercial banks has
climbed to $1.05 trillion in early June from $1.4 billion in January 2008
while lending remains in free fall. The yearly rate of growth of lending fell
to minus 11.4 per cent in May from minus 0.5 per cent in May last year.
What matters for money supply however, is not
lending as such but inflationary lending i.e. lending that was generated
through fractional reserve banking. The yearly rate of growth of our
inflationary credit proxy stood at minus 5.6 per cent in May against plus 3
per cent in May last year. (Note however that the growth momentum of the
inflationary credit proxy shows at present a visible bounce (see chart)).
Now a fall in inflationary credit, if not offset by
the Fed’s pumping, results in a decline in the money stock and hence in
deflation. As we have seen so far the money stock is still rising, which we
suggest means that for the time being the Fed’s monetary pumping via
buying of assets is offsetting the decline in inflationary credit. Observe
that currently the Fed is pumping at the yearly rate of 14 per cent against
the pace of contraction in inflationary credit of around 6 per cent. Remember
that whenever the Fed buys assets from non-banks it boosts the demand
deposits of the sellers of assets to the central bank. An increase in demand
deposits implies an increase in money supply.
So it seems that irrespective of the decline in
inflationary credit the Fed can always offset this fall through monetary
pumping. (Again the Fed could offset this fall by an aggressive buying of
assets from non-banks). So in this sense one could argue that given the
Fed’s readiness to pump money on a massive scale the likelihood of
deflation is not very high.
Now, we have to consider the fact that the Fed
doesn’t pay much attention to the money supply data. For Fed policy
makers inflation or deflation is associated with movements in the consumer
price index (CPI). After falling to minus 2.1 per cent in July last year the
yearly rate of growth of the CPI climbed to plus 2.2 per cent in April.
We suggest that on account of a long time lag from
changes in money supply to changes in the CPI the past strong increases in
money supply could lead to a further strengthening in the growth momentum of
the CPI in the months to come. In response to this strengthening the Fed is
likely to respond by tightening its monetary stance. This in turn could
significantly slow down the rate of increase in the Fed’s balance
sheet. Hence, given the decline in banks inflationary lending this will
result in a decline in money supply and hence deflation. (Even if the Fed
were to decide to do nothing, given the fall in inflationary credit this will
lead to a fall in the money supply).
There is however another factor to consider, which
is the fall in the growth momentum of money supply during November 2008 to
November 2009 (the yearly rate of growth fell from 28 per cent to minus 10 per
cent). The lagged effect from this fall is likely to produce a pronounced
decline in economic activity i.e. will severely undermine various bubble
activities. We suspect that a sharp fall in economic activity could cause the
Fed to ignore the increase in prices and embark on aggressive pumping.
The increase in the money supply as a result of
Fed’s money pumping is likely to result in a further weakening in the
process of real wealth generation i.e. a weakening in the pool of real
savings. A fall in the pool of real savings in turn leads to a fall in
economic activity – the production of fewer goods can now be funded.
Hence over time a strong money supply rate of growth
and the production of fewer goods implies a general increase in money per
good i.e. a general increase in prices. (Observe that what we have here is a
general increase in prices and a fall in economic activity, which is what
stagflation, is all about). Such a scenario is likely to be supportive to the
price of gold.
Conclusion
A sharp fall in commodity prices has raised the
spectre of deflation in the US. We suggest that what matters for deflation is
the state of the money supply. As long as the money supply rate of growth
remains positive figure there cannot be deflation. Despite a decline in
commercial banks’ inflationary credit, the offsetting monetary pumping
by the Fed has kept the money supply rate of growth in positive territory.
There is however, always the possibility that the
Fed could tighten its stance in response to a strengthening in the growth
momentum of the CPI. This, coupled with a fall in inflationary credit, could
result in a fall in money supply and thus the emergence of deflation.
However, we are of the view that on account of the fall in the growth
momentum of money supply between November 2008 and November 2009 US economic
activity could come under pressure in a few months time. As a result the Fed
may embark on strong monetary pumping. We suggest this could lead to severe
stagflation.
Frank Shostak
Frank
Shostak is a former professor of economics and M. F. Global's chief economist.
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