The deflation-inflation two-step: Too complex for deflationsts to grasp?

By mistaking the short term for the long term, they are missing the trade of the century

by Eric Janszen

Over 100 books, papers, and original analysis went into developing and refining Ka-Poom Theory over the years, and model that explains how, following the collapse of the credit bubble, the US economy will experience a short (six month to one year) period of deflation that we call disinflation, such as we are experiencing today, followed by a major inflation induced by monetary and fiscal policy and the actions of US trade partners in response to that inflation.

It appears that the deflationista camp is incapable of comprehending a model, and the events that it forecasts, that lays out a two step process. For some reason they cannot grasp the fact governments will respond to disinflation with inflation, that the impact of those interventions is not instantaneous, and that markets historically are not very good at foreseeing the change in inflationary conditions in either direction.

Ka-Poom Theory in 1999, the original disinflation/reflation theory developed nearly ten years ago, does not merely forecast a period of deflation or disinflation that is inevitable after the massive credit bubble popped. A child could do that. We call it "Ka" as the first step in the two step process outlined by Ka-Poom Theory. The difficult part is forecasting what comes after the disinflation phase. Does the Fed sit back and do nothing while the debt deflation runs out of cotnrol? Does the Fed have a choice, or does it become impotent, overwhelmed by the rate of debt defaults and money destruction?

The deflationistas apparently think what comes after post-bubble deflation is more deflation, as occurred in the early 1930s in the US but nowhere else ever since. It has not occurred to the deflationists why no similar period of deflation has ever occurred since the 1930s, or when they do confront the question they explain that the debt is really, really, really big debt this time, bigger than the Fed. Or that differences between the kind of money that the Fed prints versus the kind of money that the endogenous credit markets create when money is loaned into being by businesses and consumers means the Fed cannot impact the latter.

As we explain that in The truth about deflation, the reason no deflation spiral has occurred in any nation since the one instance in the US in the 1930s is because since then no nation has chosen to remain on the gold standard through a debt deflation. Needless to say, the US is not on a gold standard today.

What governments do when confronted with a deflation spiral is take measures to increase the money supply to induce inflation. If they succeed and money aggregates are increased, over time inflation will follow.

Money first, inflation second

One of the better papers on this topic is No money, no inflation—the role of money in the economy by Mervyn King, Deputy Governor, Bank of England. It was presented to the Festschrift in honour of Professor Charles Goodhart held at the Bank of England on 15 November 2001.
Most people think economics is the study of money. But there is a paradox in the role of money in economic policy. It is this: that as price stability has become recognised as the central objective of central banks, the attention actually paid by central banks to money has declined.

It is no accident that during the ‘Great Inflation’ of the post-war period money, as a causal factor for inflation, was ignored by much of the economic establishment. In the late 1970s, the counter-revolution in economics—the idea that in the long run money affected the price level and not the level of output—returned money to centre stage in economic policy. As Milton Friedman put it, ‘inflation is always and everywhere a monetary phenomenon’. If inflation was a monetary phenomenon, then controlling the supply of money was the route to low inflation. Monetary aggregates became central to the conduct of monetary policy. But the passage to low inflation proved painful. Nor did the monetary aggregates respond kindly to the attempts by central banks to control them. As the governor of the Bank of Canada at the time, Gerald Bouey, remarked, ‘we didn’t abandon the monetary aggregates, they abandoned us’.

So, as central banks became more and more focused on achieving price stability, less and less attention was paid to movements in money. Indeed, the decline of interest in money appeared to go hand in hand with success in maintaining low and stable inflation. How do we explain the apparent contradiction that the acceptance of the idea that inflation is a monetary phenomenon has been accompanied by the lack of any reference to money in the conduct of monetary policy during its most successful period? That paradox is the subject of my talk.
This paper contributed three concepts to Ka-Poom Theory that deflationistas should think very carefully about. Read the paper and its conclusions are inescapable.

One, if "No money, no inflation" then if "Money, inflation." Two, money first, inflation second with long and unpredictable time lags. Three, the money markets always get it wrong; inflation expectations are sticky following periods of deflation and sticky following periods of inflation. The big money to be made in our fiat money era is in betting that the bond market is getting it wrong rather than assuming that a market that is forecasting future inflation or deflation is getting it right. When governments are inflating, the bond markets tend to be right short term, wrong long term.

That being the case, this may be the trade of the century because the bond markets are pricing corporates, treasury bonds, and TIPS as if it's 1931 and the US and the world was on the gold standard, or it's 1974 and recession is about to take inflation down for the count. Mike Shedlock does a good job of describing the phenomena here recently in Industrial Bond Yields Strongly Support Deflation Thesis. The error is mistaking short term for long term inflation pricing phenomena. The one step deflationists miss is the all important second step in the two-step Ka-Poom deflation/inflation process.

King demonstrates the long term correlation between money and inflation in the UK going back to 1885.

KaPoom Theory