Some readers expressed concern about falling commodity prices, especially crude oil, and whether this will cause global deflation. This confuses the cause with the symptom.
Falling prices are largely benign except where caused by a contraction of the money supply. Commodity prices may fall when there is an excess of supply over demand, but this is soon absorbed by changes in consumer behavior. Discretionary spending will rise in response to the savings, so that aggregate demand is unaffected.
A contraction in the money supply, however, is far more serious. Slow growth in the monetary base (below growth of real GDP) results in less money chasing the same goods, driving down prices. Supply and demand in this case are unchanged, but prices fall because of a contraction in the money supply. Wages, however, are sticky and do not fall in line with prices, leading to falling profits, cuts in production and job layoffs. Falling income from lower profits and fewer jobs leads to a contraction in aggregate demand, causing further cuts to production and income.
Contraction of the money supply also places pressure on banks to reduce lending. This danger was highlighted by Irving Fisher in the 1930s. Contracting credit reduces not only new investment but forces existing borrowers to liquidate some of their assets, mainly stocks and property. The surge of selling, and limited availability of credit, drives down asset prices. A feedback loop results, with falling asset prices prompting banks to further contract lending — in turn causing more price falls. That is the central bankers’ equivalent of a perfect storm. The graph below shows how close we came in 2009 to a deflationary spiral.
Slow growth in the monetary base caused a sharp contraction in bank lending (below zero) in 2009. Only prompt action by the Fed averted a 1930’s-style collapse of the financial system.
The Fed indicated in October that it will curtail QE and no longer expand its balance sheet to support money supply growth. Should we expect another contraction of the money supply as in 2008?
The answer is: NO. When we look at the graph of the Fed balance sheet below, we can see that total asset growth [red] is slowing. But bank deposits at the Fed — excess reserves that earn interest at 0.25% p.a. — are slowing at an even faster rate. That means that the actual amount of money flowing into the banking system is not contracting, but increasing.
The following graph shows a net growth rate (of Total Assets minus Excess Reserves on Deposit) of more than 20 percent. Expect growth to slow over time, but the Fed can adjust the interest rate payable on excess reserves to ensure that it remains positive.
Deflation is a far bigger problem for the Euro. After a “whatever it takes” surge in 2012, the ECB attempted to contract its balance sheet far too soon — withdrawing treatment before the patient had fully recovered. They also do not have excess reserves on deposit, like the Fed, which could soften the impact.
The result has been faltering economic growth and price levels falling dangerously close to deflation.
The ECB appears to have recognized its error, indicating that it will expand its balance sheet if necessary to avert a monetary contraction. If they learn from their past mistakes, the ECB should be able to avoid any threat of deflation.
Appreciate your input into production of your comments.
USA CPI deflation occurred 2008-2009, while Money Supply [ie. Monetary Base, per your graphs ] increased, but consistent with sharp falls in crude oil price. So, it does not mean ‘confuse cause with symptom’.
Crude has fallen recently badly, the USA Money Supply yet is resilient. So, it may be again that USA CPI deflation can occur – all else remaining equal.
Regards
Inflation tends to lag changes in the money supply by 6 to 12 months. But there are also other factors that affect CPI like the fiscal deficit and fluctuations in commodity prices.
As always your explanations are clear (and no doubt correct, but what would I know?). I’ve accepted that I’m just too dense to understand how the good ship “Economy” carries us into our futures. Others seem to know what buttons to press and levers to pull. God I hope so; because to a passenger like me it feels like the rudders are too small and the response times are months instead of minutes. Hard to avoid icebergs that way.
The ship analogy is inadequate; to me the economy is more like a wild animal that can never be tamed, but as long as we don’t make it too angry, it will allow us ride on its back without bucking us off and stomping on our guts – until we change riders, that is, which we do every few generations.
Your final sentence is the worry. Even if this generation learns how to calm the beast, will our grandchildren remember how it was done? Do the masters of the economy, whoever they are, have a robust learning system for generations to come? Or does the beast evolve too, presenting hitherto unknown problems requiring interventions not yet imagined? What happens after all the cheap labour in the world is used up, and technology puts everyone else, even economists, out of a job? Not in my lifetime, no, but I have grandkids too.
So many questions, so little whiskey.
Nice analysis.
Generally I disagree. Inflation is theft, manipulation of money by bankers with willing connivance of politicians, as it enables pollies to make debt repayments in future, debased dollars, and allows them to spend what they dont really have. Bankers clip the ticket in both directions and award themselves huge bonuses for doing nothing productive. Deflation is actually virtous – look at its effect for the whole of mankind with deflation in the price of computers over the last 22 years, enabling vast increases in knowledge and wealth. Bankers dont like deflation as a result and so they frighten their servants, the politicians, into making inflationary policies. Even the CPI is stage-managed, as petrol and food are NOT included, and we all know how they have risen over the decades, until the recent oil deflation, which funnily enough temporarily means cheaper fuel and has the effect of a tax decrease – everyone else enjoys it!
You need to distinguish between beneficial deflation, through increased productivity and technological progress, and harmful deflation synonymous with a financial crisis as in 1930 or 2008. The latter can wreak havoc if left unchecked.
Is it also possible that in the wake of QE hedge and/or investment equity is being withdrawn from commodities due to projected increase of the $USD. As a result it seems to me that short positions have been more profitable generally in commodities of the last few months.
Covering of long positions would cause a sharp decline (opposite to covering shorts causing a rally), but this is a primary down-trend, indicating more fundamental forces at work.
If money is flowing into cash reserves and there isn’t a fundamental similarity to pre-2008 conditions, what are the fundamental forces that have been forcing commodity prices down?
Weak demand from both Europe and Asia and increasing supply has created a perfect bear market for commodities. New mines commissioned during the commodities boom are only now coming on stream, exacerbating the over-supply in commodities like iron ore.