by Jas Jain
December 26, 2005

No economic debate evokes greater emotions, or certitude, among the two warring economic camps than that about the inflationary, or deflationary, future for the US economy going into 2006 and beyond, with Bernanke coming to power and the rise in the oil and commodity prices, in general, in recent years.

I am in the deflation camp, i.e., I am a deflationist. I have been a long-term bull on the US Treasury bonds due to my long-term analysis of where in the long-term cycles the US economy currently is (yes, we are in the Deflationary Depression phase of the Longwave with the worst of the deflation not occurring in the beginning as was the case in 1931-33). As a result of my long-term view and conviction about the deflationary forces I may well have the best record in the world in my speculative positions in the US Treasuries over the past two years (returns in excess of 100% over two years while being net long over 90% of the time; I am not a in-and-out trader).

In recent years, most prognosticators have been predicting that the rates on the benchmark 10-Year US Treasury Notes will be above 5% and I have been betting on the rates not going above 5% and not staying above 4.5% for too long in any move up in the rates. While the followers of inflationists like Martin Weiss, the person with the worst record on the subject for the past 28 years that I am aware of, were buying puts on Treasury Bonds and Notes I was on the other side of such trades.

A Historical Fact

Since 1920s, the period for which I have the data, the greatest fiscal and monetary stimulus over a 3-Year period, as measured by increase in the Consumption Debt, the sum of increase in the household debt and federal deficit, excluding the period of WW II, took place in 19934-36, following the depth of the Great Depression during 1932-3. The second greatest, of almost equal magnitude, was during 2002Q4-2005Q3 (2005Q4 not being available). In the former episode, the YoY inflation rate went from �10% to +3% (with a high of 5.5%), while during the current episode of +gargantuan stimulus the inflation rate has stayed flat around 2-3% (with the high of 4.69%). Do you know what that means? The gargantuan stimuli that we are talking about exert great inflationary pressures, as all borrowed consumption does, and what it means is that the current deflationary pressures are extremely powerful and as soon as the stimulus slackens (one can’thave more than 10% of GDP a year increase in Consumption Debt for very long) the deflation will usher in.

What we had during 2003 and 2004 was a preemptive strike against the potential deflationary depression occurring early in the phase so that Bush can get re-elected and Bernanke can get appointed, but the ammo will run out as soon as the Housing Bubble, which ended up being the primary force of the preemptive strike, can’tbe sustained. In 1930s, we had the strike, in the form of gargantuan fiscal stimulus, AFTER being attacked by deflationary depression! Even during 1930s, when the stimulus slackened, the economy reverted back to deflation in 1938-39. The global forces of deflation are too powerful and no nation can borrow-and-spend 10%+ of GDP for very long.

As my late father used to say, a storm loses intensity after three days and eventually peters out. There is always some natural force that faces the storm head on. The same is true about economic forces but with different time scales.

The Arguments of Inflationists

For example, let us look at the quote from Bud Conrad, an inflationist, as to why he thinks that the long-term rates in the US will go up, �The most important driver of interest rates is price inflation. We have asset price bubbles all around, and commodity inflation. Prices are already rising, and overall measures are more like 6% per year rather than the government produced 3% levels. Even the government numbers are escalating.�

One thing that you can count on an inflationist to do is to claim that the �real world� inflation is much higher than the govt. reported inflation.

This is like making any other baseless claim one wishes to make to refute something that can�t be refuted with facts. I have found irrefutable evidence that the govt. supplied inflation data do not understate the inflation, long-term. How? By looking at restaurant prices in California over the past 25 years. Restaurant costs include almost everything that goes into CPI (consumer price inflation) and even in California, where inflation is expected to be higher over the past 25 years than in the US as a whole, the restaurant prices, where vast majority of the population eats, are up less than the reported inflation over the same period. One extreme example of this is the prices of certain items at Jack In the Box, a California-wide hamburger chain. I can’tprecisely recall the year when I first had a Jumbo Jack and a Monster Taco for lunch, but it was in 1980s. The prices at that time were $1.29 and $0.99, respectively. Then, for a period of about ten years the same prices were $0.99 each and now they are $1.39 and $0.99, respectively. Near-zero price inflation in some 20 years!

The second tactic of inflationists is to attack Core-CPI and Core-PCE deflators, favorite of the Fed, whenever the headline number, CPI including all items, is higher than these two. Furthermore, as Mr. Conrad does, they give examples of asset bubbles and claim the rise in commodity prices, etc., etc., are going to bring about future inflation. I am not going to even bother talking about another complaint of inflationists about including the rent and not the home prices in the computation of CPI. OK, when the commodity prices were falling for some twenty years, were they crying deflation, deflation? No. I wish to set the record straight in regards to these spurious claims with the aid of the attached figure and arguments.

Commodity prices, in general, and energy prices, in particular, all show up in the Core-CPI with some lag. And so do the inflationary contribution of asset bubbles. The most important thing to note in the figure is that how often the three-month change in inflation goes back to zero, or below zero.

This simply does note happen when inflation is on the rise. For example, it did not happen even once from 1968-1982. Second, twice in the past two years the 3-Month Core inflation rate went up more than 5% annual rate reflecting the pass-through of the increase in the energy prices. Since the commodities go into so many finished products, whatever inflation the commodities cause at the consumer level must show up in the Core CPI. Asset bubbles increase consumer spending, mostly by people willing to take on more debt because they feel rich, and that MUST push prices higher than what they would have been in the absence of the increased spending. No? So, every one of the things that inflationists harp on show up in the Core CPI with some time lag. Long-term, they always show up and fully.

The 3-month change in the headline CPI would be below zero when the December 2005 data is released. The only question is: How far below zero? So, the 3-month headline inflation rate would have fallen from 9% annual rate to below zero while the Core rate would be where it was over the same period.

Now you can see why the Core rate is a much better measure and more stable as well. In Southern California, wherever I drive, the gasoline prices are down anywhere from 80 cents to a dollar per gallon, down approximately 30% from the peak prices, over a period of approximately three months. It seems inevitable that both the headline and Core CPI YoY rates will be below 2% in early 2006 and would continue to fall in the absence of a War On Iran, or resumption of the Housing Bubble. The pervasive Deep Discounts during the Holidays� retail sales season is a sign of things to come.

Deflation is good and once it comes, long live deflation! Deflation would prove to be bad for the wicked and the Crooks and I love that fact in welcoming deflation. I think that secularists can learn a lot about human institutions like economics from the religionists (I am not one). Those of us who are not wicked or Crooks are no angels, but we �try to be good but can't seem to [fully] overcome evil.�

What part of efficiency, in general, and technology are deflationary don't people get? The Internet would prove to be the most powerful deflationary technology of all time within this decade. Three biggest reasons for inflation are: Corruption, corruption, and corruption! One can rank corruption in nations by the inflation rates over the past 50 years!!

Consumption debt, beyond a certain level, is a sign of a corrupt economy.

And if that is being pushed by the govt. then that is a sign of a corrupt govt. Do Americans even remember what our Founding Fathers said about govt. pushing debt on future generations? Americans are so ignor-ant because they ignor-e the warning of their greatest and most trusted leaders.

© 2005 Jas Jain
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Jas Jain

Tehachapi, CA USA

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