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Retired chief investment officer and former NYSE firm partner with 50 plus years experience in field as analyst / economist, portfolio manager / trader, and CIO who has superb track record with multi $billion equities and fixed income portfolios. Advanced degrees, CFA. Having done much professional writing as a young guy, I now have a cryptic style. 40 years down on and around The Street confirms: CAVEAT EMPTOR IN SPADES !!!

Saturday, March 16, 2013

Long Term: Inflation vs. Deflation Potential

The best and fastest way to get a handle on longer term inflation potential is to look at
a rolling 10 year record of growth for a broad measure of money and credit funding
instruments and then subtract annual productivity growth potential from it. In the wake
of the great recession, which saw well over $2 tril. of short term debt default or not get
rolled into new debt, the broad measure of financial liquidity growth for the past decade
has dropped to 4.1% annual. Pull out the reasonable assumption of 1.5% annual product-
ivity growth and you get inflation potential of 2.6%. It is no coincidence that inflation has
averaged just 2.2% per annum on a rolling 5 year basis through Feb. '13.

To get annual inflation potential up to 5%, the broad measure of financial liquidity in the
system would have to be about $4 tril. or nearly 26% higher than it is today. Given how
conservative banks remain, such rapid growth in credit demand soon seems rather unlikely.

To get inflation going strongly for a goodly spell requires not just fast money and credit
growth but high rates of resource utilization and a sharply elevated level of wage growth
to sustain it, all of which we saw over the great inflation period of 1965 - 80, which
incidentally was a an era of low productivity growth. Tossing in a major war might also
help get inflation going.

I would argue instead that the US economy has become deflation prone and has been so
for the past 7 - 8 years, commodity driven mini inflation surges notwithstanding. US
real growth has been very scant in real terms, resource utilization has been declining and
business has succeeded in wringing productivity from an employment base that is nearly
flat. On top, the wage in current $ has been coming down (from 3.5% to 2.1% currently).

The Fed has added nearly $2 tril. in credit to the system to re-inflate it since 2008. The
economy is, in turn, still recovering slowly with the $ value of industrial output running
nearly 24% below the long term trend. To add a little excitement to the mix, The US
Gov't is looking to join the states in cutting spending and jobs. Small wonder then that
top notch economists like Paul Krugman and Joe Stiglitz are not just dismayed but are
appalled instead. Can deflation be virtuous in a well leveraged economy such as ours?
Dream on.

The Fed needs to keep plugging away until the economy takes up more of the capital
slack in the system and shows itself as able to sustain growth on dramatically more
limited help from the Fed.

Up next: shorter term inflation potential... 

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