Tuesday, September 30, 2008

Merrill: On Inflation or Deflation?

Those who believe that we’ve managed, in one day, to switch from a deflationary to an inflationary backdrop because of additional government debt creation are not taking into account the offsetting credit contraction in the private sector, which comes from three sources: asset liquidation, debt repayment and increased savings. The Fed and Treasury are merely cushioning the massive deflationary forces in the financial system.

We are getting asked repeatedly these days how it is that the government debt creation we are about to see is not going to be inflationary. After all, aren’t we going to see a boom in the money supply? Well, we’re sure that the money supply is going to increase, but at the same time, we are going to see the turnover rate of that money, or what is called money velocity, decline. This is exactly what happened in that 1989-93 period when the Fed massively reflated. Money velocity contracted 13% and this is the reason why the inflation rate was cut in half that cycle and bond yields rallied 400 basis points, though no doubt that downtrend in yields was punctuated by intermittent corrections – as we’ve seen take place in the Treasury market over the past week.