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Cycles of Deflation
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Posted on: Wednesday, June 4, 2014
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INFLATION vs. DEFLATION
The Cycle of Deflation-authored by Comstock Partners
U.S. M2 MONEY SUPPLY VELOCITY GDP M2
M2 & M1 MONEY SUPPLY VELOCITIES
VELOCITY OF MONEY
HOUSEHOLD DEBT AS A % OF GDP
HOUSEHOLD DEBT AS A % OF DISPOSABLE PERSONAL INCOME
FED BALANCE SHEET vs. S&P 500 INDEX
MONEY SUPPLY/ MONETARY BASE = MONEY MULTIPLIERS
EUROZONE HOUSEHOLD DEBT as % of DISPOSABLE INCOME
Most investors are bewildered by the fact that interest rates on the 10 year U.S. Treasury have
been going down year to date from 3% to 2.5% after rising from about 1.6% to 3% last year.
At the end of last year virtually everyone expected interest rates to rise this year while the Fed
tapered their purchases and the economy improved. In fact, the surveys taken by CNBC
showed that every single economist predicted higher interest rates this year. Whenever you
get a consensus so strong in these liquid markets you will find that they almost never pan out,
and the masses going along with this crowd get fooled.
We believe that this consensus of people who believed that interest rates would rise will now
agree falsely as to why the 10 year Treasury declined. Everyone seems to try to explain the
move down as either a weaker economy or a short squeeze. We have been calling for a
decline in interest rates for some time due to the world-wide deflation which we have been
discussing in our comments for years. There is not much difference in the debt levels,
especially in the financial sector, between the U.S. and Japan back in 1989. That was when
Japan fell into the deflation trap (or liquidity trap explained later) that lasted for the past
25 years. We have used the Cycle of Deflation (first attachment) since the early 2000s and
it couldnt be clearer to us that this is the most likely scenario for the United States.
Last week the financial television shows interviewed numerous extremely sharp economists
who all were concerned about inflation being the main problem this country will surely have to
deal with over the next few months and years. One of them showed a chart of inflation being
1.1% at this time last year, 1.5% at the end of last year (2013) and 2% presently. He
believed that this trend would continue moderately higher over the next few months and
accelerate from there over the next few years. He did not think it would be horrible hyper-
inflation, but one that would need the Fed to deal with the rising prices. He also believed that
Ben Bernanke was not as concerned about inflation as he should have been when he was the
head of the Fed.
Another economist stated that, at a minimum deflation is dead. He was concerned about the
rising prices of food, energy, and rents. He also believed that wages are a lagging indicator
and with four months in a row of rising non-farm employment greater than 200,000 (he
assumed that May would also exceed 200,000) wages would rise much more than they did in
the past and since wages represent 40% of the core CPI index.
The other economists added more concerns to the above bringing up the fact that the cost
savings for prescription drugs is now over, and the prices of cars and clothing are now rising.

Global wages should rise from 2.5% to 3.5-4% as other central banks like the ECB and the
Peoples Bank of China will be following us and the Japanese in easing as their economies slow
down. Inflation rates are on the rise and the Fed is behind the curve.
These economists that I referred to above are very sharp and present a powerful case for an
inflationary scenario not only in this country but globally. We, on the other hand, strongly
believe that this onerous debt that was generated from the early 1980s to present will more
than likely end with the debt collapsing into a deflationary depression or another great
recession both here and abroad. We would put a probability of around 60% on a deflationary
outcome, but we also agree that if it doesnt end in deflation, the next highest probability
would be hyper-inflation and we would put about a 25% probability on that (with a 15%
probability of muddling through with the debt continuing to expand for years).
VELOCITY OF MONEY
Our problem with the inflationary scenario is the velocity of money and multiplier of money.
As far as velocity goes, the turnover of our money supply has been declining since the middle
of the 1990s from 2.2 velocity to 1.5 now, and as it continues to decline we will not experience
the recovery strength we witnessed after every downturn since the great depression (see
2nd attachment). The M1 Velocity (GDP/M1-see attachments #3--# 4) has declined from 10.5
in 2007 to 6.3 presently). When the consumer is overburdened by debt he or she is afraid to
continue borrowing and spending, and most banks are reluctant to loan money to anyone
except the most credit worthy. Under this scenario the velocity will continue declining
producing a lower than normal money supply and GDP.
The consumer debt relative to GDP jumped from a long term average of less than 50% for
decades leading up to the middle of the 1980s where it grew to over 95% in 2008. We are
now at 77% on the way back to the past 50% norm (see attachment # 5). In a similar
attachment # 6, consumer debt to Personal Disposable Income (PDI) was under 60% for the
decades of 1950 to the middle 1980s to almost 130% of PDI before the great recession
starting in 2007. After peaking in 2007 the H/H debt to PDI has declined to about 105%
presently on the way back to the norm of 60%.
MONEY MULTIPLIER
Another reason we are putting such a high probability of deflation (60%) versus inflation
(25%) and muddling through (15%) is because of the money multiplier which determines how
much the money supply grows relative to the monetary base. You see, the Fed can only
control the Monetary Base and the Federal Reserves balance sheet. The Fed balance sheet
grew from $800 bn. in 2008 to $4.1 tn. now, and most inflationists believe that unwinding that
much money will create hyper-inflation (see attachment # 7). The Fed uses their tools of
lowering the Federal Funds rate (the rate that the banks can borrow money from the Fed) and
purchases of government bonds as well as mortgage backed securities (or Quantitative Easing
--QE). They can also issue low cost Certificates of Deposit CDs to the banks as well as
reverse repos, but the main tools of the Fed are lowering rates and QE. However, these tools
dont directly control the Money Supply (MS). How much M2 grows is dependent upon the
money multiplier and if it continues down as it has lately (see attachment # 8) the money
supply will continue to be hampered by this multiplier.
LIQUIDITY TRAP
Another problem with the inflationary scenario is the liquidity trap we are struggling to
escape from presently. This is a situation in which prevailing interest rates are low and
savings rates are high, making monetary policy ineffective. In a liquidity trap, consumers
choose to avoid bonds and keep their funds in the safest investments because of the prevailing
belief that interest rates will soon rise. Because bond prices have an inverse relationship to
interest rates, many consumers do not want to hold an asset with a price that is expected to
decline.
In this situation, banks sell their bonds to the Fed and receive cash, but instead of loaning the
dollars out they deposit the money back with the Fed as excess reserves and therefore the
dollars do not recycle or circulate. This prevents the money supply from growing, and
eventually has a deflationary outcome. You can supply all the money the Fed wants by
increasing the Monetary Base, but if the public and corporations dont want to borrow the
money, the money supply is restricted and when you think there will be inflation, instead there

money, the money supply is restricted and when you think there will be inflation, instead there
will be disinflation and possibly deflation.
So, it seems to us that because of the velocity of money, the money multiplier, and the
liquidity trap, inflation will be postponed indefinitely and replaced by disinflation or even
deflation. The global environment for inflation is also on the side of disinflation as the
European Union just reported an inflation rate of only 0.5% and Germanys inflation rate was
only 0.6%. The ECB will attempt to address these deflationary indicators this week (please
see last attachment). And if Chinas GDP growth continues on the downward growth path they
could lead the way to emerging market weakness and disinflation or deflation.

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