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Deflation by Dictatorship

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"Will the end of QE2 produce a deflationary global shock?"

There are two major considerations for the nation's economic and financial health as we enter the second half of 2011. Each can be addressed in the form of a question: 1.) Will the Federal Reserve embark on a third attempt at stimulating economic recovery through money printing; and 2.) Has the cyclical bull market that began in March 2009 peaked—and further, what will happen to the financial market once the 6-year cycle peaks in October? We'll attempt to answer both questions in this commentary.

The Fed's quantitative easing 2 (loose money) program is about to expire and, for many, the last day can't come soon enough. Though it's debatable that QE1 was necessary and had a salutary effect on financial markets and the economy, QE2 was both unnecessary and its longer-term future effects could still be disastrous. If nothing else, QE2 has served as a reminder that the Fed always goes too far in carrying out any of its policies—whether they be tight or loose money—QE2 was no exception.

One example was the Fed's deliberate inversion of the Treasury yield curve in 2006–07 that led to the financial crisis of 2008–09. Although many factors contributed to the worst financial disaster since the Great Depression, without the Fed's tight money policy it almost certainly would have been less severe and shorter in duration. Fed Chairman Bernanke's decision to invert the yield curve was based on a flawed Keynesian view of the economy, which assumes that inflation is a product of full employment.

After the credit crash of 2008 showed Bernanke the error of his ways, the Fed reacted by taking the opposite course and aggressively loosened money by dropping short-term interest rates to nearly zero. Then came the Treasury-purchasing programs designed to further increase monetary liquidity. The only problem with this is that the Fed never knows when enough is enough, and this time was no different. Not content with the first quantitative easing initiative (QE1), Bernanke felt it was necessary to have yet another one and so along came QE2 late last year.

One of many unwelcome consequences of QE2 was a big increase in oil and food prices as well as a broad array of commodities. This has had a spillover effect in raising prices paid by consumers on a number of goods, and as the lag between commodity futures price increases and consumer prices is at least six months on average, it will mean that consumers will be paying for Bernanke's monetary mistakes until next year. The Fed's timing couldn't have been worse, for once the 6-year cycle peaks in October—and assuming the Fed doesn't start up with QE3 by then—the economy will likely have some rough headwinds into 2012.

To give an example of just how big a problem increased consumer prices will be later this year, last week's issue of BusinessWeek noted that due to higher labor and material costs, China's toy industry is already preparing for a series of price increases. "There is a big chance for shoppers in the U.S. to face higher prices for Christmas gifts this year," said a Beijing analyst quoted by BW. The article went on to say the pressure's coming from higher commodity costs due to the run-up in cotton and crude oil prices.

Inflation pressures in commodities and real estate in the world's second largest economy have led China's central bank to embark on a campaign of monetary tightening. It has raised interest rates four times since October—most recently on April 6—and just this week, increased the amount of capital banks must keep on reserve by half a percentage point. China's CPI rose 5.5% in May from a year earlier and is growing at its fastest pace in three years.

Getting back to Bernanke and QE2, sometimes it helps to know the philosophy behind a policy. For this, I'm grateful to an article by Richard Salsman appearing in a recent issue of Forbes. Mr. Salsman quoted a 2002 speech by Bernanke in which the Fed Chairman said that the Fed "retains considerable power to expand aggregate demand and economic activity even when its accustomed policy rate is at zero," for it "has a technology called a printing press (or, today, its electronic equivalent) that allows it to produce as many U.S. dollars as it wishes at essential no cost," and by this method it can "reduce the value of a dollar" and thus "raise the prices in dollars of those goods and services."

Investors could certainly be forgiven for assuming that the temporary spike in commodity price inflation this year was a presage for an even bigger hyper inflationary trend. This isn't going to be the case, however, as the long-term super cycle is in its hyper deflationary phase until late 2014. The Fed's effort to fight this deflationary force by inflating money and credit can only lead to more deflation down the road. The reason for this is that in a deflationary super cycle like the one we're now in, aggregate demand is on the wane (contrary to Mr. Bernanke's belief). Neither the Fed nor the government seems to realize this because their proposed solutions to the economic recession have been to try and stimulate demand by creating more money.

Money creation, however, doesn't create demand, although product creation can actually stimulate demand. Within the 30- and 60-year cycles, demand can be stimulated, to a degree, by monetary manipulation—but only when the cycle is in its ascending phase. In a declining cycle, monetary creation can only result in a temporary imbalance of supply and demand that may have the intended effect of boosting prices (for a time) but ultimately demand fails to keep up with the degree of artificial money creation and prices collapse.

David Knox Barker, in his latest Long Wave Dynamics letter eloquently describes the Fed's dilemma: "The current strategy of socializing losses by trying to restore the big bank's balance sheets with the spread between zero rates and its government bond holdings is simply punishing savers, reducing economic growth and delaying the recovery process. Aggressive monetary policy is keeping excess global production capacity online when it should be shut down to reduce the building deflationary pressures. Counterintuitively, loose money leads to deflation after transitory inflationary pressures."

Mr. Barker suggests that the end of QE2 may produce a deflationary global shock. He further suggests that Bernanke may capitulate to the "drum beat for QE3 already coming from some on Wall Street that are counting on their year-end bonuses from the spread between zero rates paid to savers, and what they expect to earn on their Treasuries, wheat and oil." Barker, who is a highly regarded expert on the Kondratieff long wave, believes that a few trillion more in quantitative easing (QE) and more government intervention could carry the present long wave "winter" into 2016, "buy by then the resolutions will have come to the developed world, maxing out the degrees of freedom."

Monetary manipulation isn't the only way Washington is trying to stimulate demand, however. In the latest surprise development, the International Energy Agency announced the release of 30 million barrels of oil from the nation's strategic petroleum reserve. The move was ostensibly made to relieve pressure on the global economy from rising pump prices. While this move might have been laudable had the retail gasoline price risen above $4/gallon, it's a debatable policy to unleash strategic oil reserves when oil and gas prices have in decline for the last two months.

If ever there was a time to release oil reserves in the name of stimulating the economy, it was back in 2008 when the oil prices were heading toward an all-time high of $145/barrel. The President at that time resisted calls to release strategic oil reserves, which undoubtedly would have brought some relief to beleaguered consumers as well as putting a check on speculators. As it turned out, the credit crash eventually rendered this point obsolete, but not before the rising oil price did considerable damage to the global economy. The main issue here is that the time to release oil reserves is when petroleum prices are high and going higher, not when prices are in a downward trend. Another question that must be asked is whether the decision to release oil reserves was done to assist the oil "shorts."

Ultimately, the decision to release oil reserves at this time is yet another example of how official policy can only feed the underlying deflationary trend. The first instance of a destructive deflationary policy was seen earlier this spring with the CME's decision to raise margin requirements on silver contracts. The result of this decision not only saw a collapse in silver prices but also a spillover decline in other asset prices, including oil.

In light of the above examples, one gets the sense that regulators including the Fed, exchange officials and Washington policymakers, all believe they can dictate their will to the market and successfully fend off deflationary pressures. The temptation to also use policy to manipulate markets for the benefit of their friends on Wall Street is also a problem.

One thing is certain, though. The final descent of the Kress super cycle in 2012-2014 will divorce policy makers of the notion that they can dictate to markets their will. As we travel along the hard road to 2014, it will be discovered to the chagrin of the dictators that the only thing they have successfully dictated through their policies is deflation.

Omens and Prodigies
In the ancient world, omens and prodigies were regarded with superstitious reverence.

It was believed that God (or the pagan gods in the case of the Greeks and Romans) always gave a sign before bringing about a major social catastrophe or natural disaster. For those in modern times who give credence to omens, the mysterious death of over 7,000 blackbirds and 100,000 fish in Louisiana at the start of this year could be regarded as a portent of catastrophes to come. (Indeed, one could be forgiven for pointing to this year's abundance of political revolutions and natural disasters both in the U.S. and around the world as being at least a partial fulfillment of these omens).

From a secular standpoint, omens and portents are not infrequently seen in the financial markets. Signal events in major equity or commodity markets often presage even bigger, seismic shifts in the market or even the economy. One such example of a market "omen" would be the crash in the silver market earlier this spring. There are two major lessons that can be learned from the recent silver crash. The first lesson is that policy, no matter how well intentioned, can have profoundly negative consequences on the market. The other lesson is that markets are hyper-sensitive to abrupt changes in policy given where we are in the long-term deflationary cycle.

We've seen several instances in just the last few months how policy is being used to manipulate markets (Treasuries, silver and oil). Yet in every case, these policies have backfired and have actually fed the deflationary trend. The Federal Reserve has had a relatively easy going in rejuvenating the financial market with its loose money policy in the last year due partly to the fact that the last of the long-term cycles, namely the 6-year cycle, is still up. The 6-year cycle is due to peak this October, after which time the Fed will likely have its work cut out for it in terms of artificially sustaining the inflationary trend in both stock and commodity prices. Once the 6-year cycle has peaked, there will be no long-term cycle of consequence (beyond the 4-year cycle) up until after 2014. It, therefore, behooves us as wise financial stewards to prepare for the tough road ahead.

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