The Inflation Fears are Muted as a Renewed Threat of Deflation

jingriver

Notes From Underground: The Inflation Fears are Muted as a Renewed Threat of Deflation Appears on the Horizon
By Yra

Global equity markets have been under pressure as the economic data from all regions of the world has been weaker than expected. British industrial production numbers were horrid and other areas in Europe have also experienced worse than anticipated activity. Low-money rates have been successful in pumping up many asset classes, especially since Jackson Hole Speech of August 27, 2010. The developed world’s CENTRAL BANKS have been creative in finding ways to keep REAL INTEREST low if not outright negative, making investors holding of cash a losing endeavor.

The looming possibility of a default by Greece and other European peripherals is exerting great pressure on the large European banks, pushing them to hoard capital and curtail lending to ensure having adequate reserves. The ECB is also facing the probability of large losses on their holdings of Greek debt placing restrictions on the European creation. The problem is further magnified by the fact that large U.S. banks have sold large amounts of CDS (CREDIT DEFAULT SWAPS to European creditors, putting more pressure on the balance sheets of the systemic-risky lending institutions. If there is a legally declared DEFAULT, the hit to the large global financial institutions could be LEHMANESQUE.

This is not a new story but it seems to have gained in significance because the developed economies have weakened and thus, the impact from any large credit event would be more harmful. U.S. GDP at 1.8% is not strong enough to shoulder the burdens of a recessionary Europe and a battered Japan. The U.S. housing market is a continuing drag on the balance sheets of banks and consumers. If the FED proceeds with the expiration of QE2 and fails to communicate any type of plans for further action to stimulate economic activity, will  Bernanke and the CLASS of 1937 just allow deflation to set in as the developed world leads the way for a massive LIQUIDATION of all asset classes in order to restore strength to devastated balance sheets? The answer to the question I pose is going to drive trading for the next six months as markets are left to conjecture as to the path that the economic and political policy makers choose to take.

I believe that the fear of DEFLATION is what keeps Chairman Bernanke awake at night and it is having more sleepless nights of late. The FED will have to examine all of the tools at its disposal to determine what will be available to prevent a mass LIQUIDATION OF ASSETS. Analysts have spent much time contemplating QE3 but what we may see will be a repeat of the FED fixing long-term interest rates at a level that will mean a NEGATIVE REAL RATE of interest-forcing money out of BONDS and into other assets. This was done in the 1940s and only removed in 1951. A hat tip to Professor Kevin Waspi for recommending a Bernanke paper delivered in January 2000: “Japanese Monetary Policy:A Case of Self-Induced Paralysis.” It is an important time to be aware of the thought processes of the FED chairman. The paper is very easy to read and well worth the effort.
In his conclusions for Japan to relieve the heavy burden  of DEFLATION, Mr.Bernanke advised taking all types of NON-STANDARD measures. He advised the Japanese MOF and BOJ to undertake policy with ROOSEVELTIAN RESOLVE and said:

    “In the end, the most effective actions he took were the same that Japan needs to take. Namely, rehabilitation of the banking system and devaluation of the currency to promote monetary easing. But Roosevelt’s specific policy actions were, I think, less important than his willingness to be aggressive and to experiment, In short, to do WHATEVER WAS NECESSARY TO GET THE COUNTRY MOVING AGAIN (emphasis mine).”

  I am trying to prepare the readers of NOTES FROM UNDERGROUND to be prepared for many different FED actions and not to fall prey to the limitations of QUANTITATIVE EASING. It’s exactly why I live a world of 2+2=5.