2009-06-22

Mish Makes the Case for Deflation

and refutes an argument for inflation. Check out "The Big Inflationist Scare"
However, Gary's hypothesis "the Federal Reserve can re-ignite monetary inflation at any time by charging banks a fee to keep excess reserves with the FED", is just that, a hypothesis, and I believe a very poor one at that.

Bernanke's idea to pay interest on reserves will slowly recapitalize banks over time. This is why he desperately wanted to do so. To suggest he is about to charge interest on deposits is silly.

The key fact now is there are not enough credit worthy customers for banks to want to lend, or for that matter willing borrowers looking to expand debt. Thus, if banks had to pay interest on reserves, rather than causing mass inflation, the Fed would cause mass panic.

Indeed, the likely result would be banks scrambling for dollars to repay the Fed as opposed to a mad dash to lend dollars.

Clearly the Fed understands this. Thus, it's not the Fed who is screaming about the banks' unwillingness to lend; it's Congress. Moreover, banks won't lend because most of them know the score as well, regardless of what lies they tell the public about being well capitalized. This is why "reserves" are accumulating in the first place.

Of course those "excess reserves" are a mirage; they don't really exist. Banks need those reserves because of the massive wave of credit card defaults and foreclosures yet to hit the books. Every uptick in unemployment exacerbates credit card losses, foreclosures, losses on home equity loans, etc, something that Gary North ignores.

So charging interest on reserves would not bring about inflation, it would cause a systemic deflationary crash if Bernanke was foolish enough to attempt it.
Read the whole thing. I agree with Mish on every point, especially the facts: rising savings rates, tighter regulation, and more credit losses.

One point I made recently is that if the Fed wanted to inflate, it first needs deflation anyway. I do not believe it is possible to inflate when everyone is watching. Who will be the sucker to lend money at 4% when "everyone" knows the Fed will create 6 or 7% inflation? You have to have everyone looking for deflation or complacent with low inflation. When everyone is looking for inflation, you get bond vigilantes and people piling into oil futures. When commodity prices soar and interest rates head higher, Fed printing will cause rates and commodities to skyrocket in pure bubble fashion. On the other hand, if the Fed does nothing, it acts as a deflationary force on the economy. Zero Hedge excerpted a David Rosenberg report on June 9, to wit:
U.S. retail gasoline prices are now up a full buck from the lows, to $2.62 a gallon (up 41 days in a row) — the equivalent of a $130 billion drag on discretionary spending at an annual rate. Tack on the 60bps bounce in mortgage rates too, which has triggered a near-60% collapse in mortgage refinancings. Then tack onto that the 0.2% decline in average weekly earnings in May — down now in two of the last three months — and a consumer relapse could well be in the offing and end up snuffing out this ballyhooed inventory-led recovery that has underpinned equities and undermined Treasuries over the last 3-4 months.
Higher oil prices and higher energy prices, the supposed signs of hyperinflation, threaten to derail the recovery. Ben Bernanke probably thinks he lives in bizarro world. He's fretting about deflation, but won't publicly say anything lest he frighten the public. On the other hand, he's painted as helicopter Ben. Millions of people are making his job much harder by threatening high inflation at the drop of a hat and their actions will exacerbate any deflationary flare up. The actions of the inflationists themselves indicate deflation!

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