Comstock Partners, Inc.September 04, 2014
Different Positions about the Federal Reserve's Policies
Many sophisticated institutional investors are in a camp that believes the Fed is behind the curve and if they don’t raise rates soon we will have a high probability of entering a period of either bad inflation, or possibly even hyper-inflation. Other camps are supportive of the Fed’s policies in varying degrees.
The example used by the first camp shows that if an economist was on Mars over the past 5 years and landed in this country, he would see that we had a decent recovery with the unemployment rate down to 6.2% (almost full- employment). The rate declined from 10% in October 2009 to 6.2% presently, and inflation, based on the CPI, of over 2%. He would not believe that the interest rates controlled by the Fed (or Fed Funds Rate) would still be at 0 to 0.25%. He would have thought that the Fed is so far behind the curve that, by the time they started raising rates, inflation would be “out of control”.
Another camp believes that the Fed is using the correct policy of not raising rates because half of the countries in the world are either in a recession or about to enter into a recession. Witness Japan with negative GDP of 6.8%, Italy that just entered their third recession, Germany and France about to enter a recession, almost all of South America already in recessions, and China’s recent debt contraction and real estate over building will drive them into a major slowdown or crash. Even though the U.S. was in the best shape of the developed countries we would not be able to “go it alone”. And if the Fed raised rates we would be in even more trouble than the other developed countries.
We, at Comstock, believe that the excess debt, not only in the U.S. but globally will drive developed countries into a deflationary scenario that could be worse than the “great recession” we experienced in 2007, 2008, and 2009. We see the decline in commodities (corn, soybeans, hogs, sugar, copper, energy, and even precious metals), and the decline in interest rates throughout the globe to signal deflationary forces at work. We have been worried about this for some time using the “cycle of deflation” (attached) to make our point. The cycle is still stuck in the competitive devaluation of currencies segment. We have used this chart many times in these comments that show the effect of over indebtedness just like the U.S. in 1929 and Japan in 1989. We wrote the “special report” called “Inflation vs. Deflation” in June of this year. We sincerely wish to be wrong about this, but that is our position!
A piece written just this week by the St. Louis Fed confirms our opinion and goes into the same reasoning we used in the June report. Their report is called “What Does Money Velocity Tell Us about Low Inflation in the U.S.”? It shows why the U.S. consumer is hoarding money instead of spending it and generating the inflation that is normally caused by the typical money printing by the Fed. They explain that the reason for hoarding instead of spending lies in a combination of two issues: 1. A looming economy after the financial crisis. 2. The dramatic decrease in interest rates that has forced investors to readjust their portfolios toward liquid money and away from interest-bearing assets such as government bonds. In this regard, the unconventional monetary policy has reinforced the recession by stimulating the private sector’s money demand through pursuing an excessively low interest rate policy. (i.e., the zero-interest rate policy). In this same piece, just published, they show why increasing the monetary base is not increasing inflation because “money velocity” is declining dramatically. They state, as we did in “Inflation vs. Deflation”, “if the money velocity declines rapidly during an expansionary monetary policy period, it can offset the increase in money supply and even lead to deflation instead of inflation” (see attachment).
Finally, we have some support from the "main stream" for our “cycle of deflation” coming from the well-respected St. Louis Federal Reserve.