Confronting Deflation - September 11, 2015

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Greetings,

In 2011, economic historian Russell Napier gave a speech in New York on the modern dangers of deflation. When it came to Japan, which has been stuck in a deflationary trap since the early 1990’s, Napier pointed out, “Japan has tried several times to reverse the direction of prices, but it’s never tried very hard.” That seems like an absurd thing to say. The Bank of Japan (BoJ) has kept policy rates below 0.5% since 1995 and its balance sheet is more than 60% of GDP, but there’s at least a grain of truth in that statement.

The BoJ is ravenously seeking CPI growth of (at least) +2.0% Y/Y, and continues to run the most experimental monetary policy in the history of fiat currency. But no matter how you slice things, Japan’s central bank is failing to achieve its goal; CPI was +0.2% Y/Y in July. It seems like the BoJ is pushing the limits of responsible policy to generate inflation, but what if our assumptions about these “limits” are way off. After all, fiat currencies have only been around for 45 years and long-term debt cycles typically last between 75-100 years. There is almost certainly a level of stimulus that would generate inflation… it just wouldn’t be very popular socially, politically or internationally.

In 1979, Paul Volcker became the Federal Reserve chairman and took an uncompromising stance against inflation. His decision to hike interest rates to 20.5% (twice) pushed unemployment above 11% in the most painful recession since the Great Depression. Volcker was appointed by President Jimmy Carter, but his tough medicine likely contributed to the Democrat’s failure to win reelection in 1980. Volcker was one of the most disliked public figures in the United States at the time. Today, he’s lionized for standing up to the market. His 2004 biography was subtitled, “The Making of a Financial Legend.”

Volcker’s successor was Alan Greenspan who famously introduced the Great Moderation, which sought to eliminate the business cycle through incremental adjustments to monetary policy. That strategy served the US well for twenty years, but maybe it’s time for a more confrontational approach. Since 2008, there’s been little evidence to suggest that the US and Europe aren’t in the same deflationary trap that has plagued Japan for decades. CPI growth in all three regions will almost certainly fall below zero this year, probably this month, and Larry Summers’ forecast of secular stagnation looks better every day. The BoJ, ECB and Fed have been trying to push prices higher, they just have been trying hard enough.

What would “trying hard enough” entail? It certainly wouldn’t be popular with a large percentage of the population. The classic example is helicopter money, which wouldn’t necessarily involve flying currency but rather capital injections into personal savings accounts. A broad-based cancellation of debt obligations would be another option. Even a tax cut would help. Worries that the Fed is “out of ammo” are misplaced, because they’ve got plenty of firepower left – much of it nuclear. Where there’s a will, there’s a way. Remember, QE was unthinkable ten years ago, but Bernanke was applauded for its implementation because everyone was terrified of the market action. Unfortunately it looks like we’ll need to see more stagnation before policymakers stare down deflation.

The Cup & Handle Fund is up around 5.0% YTD, and +20% Y/Y. The base effect is hitting Y/Y returns and YTD numbers should be higher but I’ll stick with these positions through next Thursday. Added a new long this week, which has good potential. The calls have been correct, it’s just tough to trade through the swings. The September letter went out two weeks ago and it’s roughly flat, but should start moving soon. If you’d like to start receiving these letters click here.


With that I give you this week's letter:

September 11, 2015


As always, if you have any questions or comments or just want to vent, please send me an email at mike@cup-handle.com.

Until next time, tread lightly out there,

Michael Lingenheld

Managing Editor – Cup & Handle Macro

Posted to Cup & Handle Macro Research on Sep 10, 2015 — 3:09 PM
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