The mystery of deflation

Outlook:

We have a big calendar today that includes the usual Thursday jobless claims, industrial production, TICS, the Philly Fed and speeches by Feds Lockhart and Kocherlakota. Industrial production is the “real” data and is expected to be better than -0.1% in Aug, but it’s probably not big enough to reverse negative sentiment all on its own.

The New York Times (yes, the NYT) has an intriguing comment on the partial reversal of equity for-tunes yesterday. The Dow was down 2.8% at one point but then recovered to close down a lot less, only 1.06%. “What caused the sudden rally in the stock market just before 1:30 p.m. is not clear. But it may have been fueled in part by a report from Bloomberg News saying that Janet L. Yellen, the chairwoman of the Federal Reserve, had expressed confidence about the United States economy at a closed meeting in Washington last weekend.”

The implication is that panic about global deflation and recession, and specifically about other countries’ deflation and recession being contagious to the US, is not warranted, and more importantly, that a well-placed comment from the top Fed can halt a rout based on fear alone.

Yellen spoke while US equities were correcting downward but before real panic had set in. The question now is whether additional Fed remarks about contagion and/or about the strength of the US economy could actually halt the correction, or ameliorate it. And if so, is that something we want the Fed to do? The Fed doesn’t see managing stock markets as one of its jobs, but financial stability is one of its jobs, and it just named Vice-Chairman Stanley Fischer to head a committee on financial stability, so maybe a comment or two is appropriate.

It’s certainly an interesting question and we’d bet a buck it is exactly what the Feds are talking about amongst themselves. After all, investors in US equities have lost about $2 trillion in the last month and VIX is at the highest since the last global crisis in 2011. If not now, when? Well, one plausible reason for delay is that the earnings season is just starting. It would be far better (from the imagined Fed point of view) for the market to fix itself based on earnings than because of something artificial like Fed ver-bal intervention. Besides, the Fed is not entirely ignorant of technical considerations. Many, many chart-ists had been calling for a correction for a long time of at least 10%. Maybe the wise course of action is to let the market fix itself in its own time and in its own way. Net-net, we do not expect the Fed to speak up against falling equities. It would not be surprising to hear someone say that no one understands the dynamics of such enormous markets with so many diverse players, and hands-off is the only sane ap-proach.

Another reason for the Fed to keep its mouth shut is that any comment denying real economic contagion would have to blame Patient Zero, which is Europe. We can blame the crisis of 2008 on the US, but the crisis of 2011-12 belongs to Europe, and Europe never fully recovered from it. Confidence in institutions was based almost entirely on Draghi’s “whatever it takes” remark, but everyone knows that the policy measure behind it, Outright Monetary Transactions, was never actually implemented. So OMT is not real. Neither was the Greek bailout, which was never going to work, and the Cyprus bailout, which was a disgrace revealing that the state is still willing to screw the average Joe, a profoundly un-modern mind-set.

And that leaves us with the mystery of deflation, one of the least understood of all economic phenome-na. A couple of points: Bernanke joked that QE works in practice but not in theory, and yet that’s not really true. At bottom, QE is a rise in money supply, and if money supply exceeds activity by enough and for long enough, eventually you get inflation. For some reason not well understood, inflation itself inspires a rise in activity, which is what you want to end recession. This is why Keynes recommended wild fiscal spending and also why Roosevelt expropriated citizens’ gold in 1933, turning around and putting the gold-backed cash back into the economy. We have never seen an estimate of the increase in economic activity from the gold move, but the effect can’t have been zero.

Patient Zero is not China or other emerging markets, as we expected, but Europe itself. That means the fate of the global investor’s wealth is in Mario’s hands. Analysts are still speaking of QE in the first half of next year. We say it’s needed, or rather something is needed, before then. Central banks may want to keep their hands clean from equity markets, but it’s their job to alleviate panic.

And let’s not forget one of the key factors underlying deflation—the fall in commodity prices, especially oil. At a guess, the oil price drop was a little overdue—we had been seeing a lot of data about US pro-duction toward self-sufficiency for many months without the price responding appropriately. The excuse was Middle East turmoil. But the immediate trigger for the current price drop is Saudi Arabia not acting in the usual manner—cutting production to support the price. To go for market share instead is a totally new tactic by the Saudis, and nobody knows how to interpret it. It’s a classic monopolist play—underprice the competition until they go out of business. The Saudis don’t really think they will kill the fracking/shale oil industry in the US and Canada, do they? Probably not, but they can certainly get the other OPEC members at their feet begging for quota cuts in November in Vienna. It would be silly to blame the European recession on the Saudis—the Europeans have plenty of fault of their own—but to the extent the price of oil is a key factor in European deflationary recession, the Saudis are showing off their power. (Why not just impose a giant tax on oil and spend the revenue on infrastructure?)

When markets get in a panic, any old excuse will do as a reason to sell. The Big Picture is not that bad—as we keep saying, lower oil prices puts more disposable income into the pockets of most businesses and households. But the Big Picture is now colored by a gloomy shade of gray, warranted or not. Hang on to your hat.

Note to Readers: We have jury duty next week on Tuesday 10/21. If we do not get a message Mon-day night that we are excused, there will be no reports on Tuesday.