Economic recovery will come with inflation as added cost

Wall Street, today, cleaves along a singular fault line. Will there be the inflation or will deflation follow, despite all efforts?

Not withstanding Mark Twain's quip that while history might not repeat itself it sure does rhyme the same – historical angst is writ large. Will America head back to the high-inflation regimes of 1970s or will America transmogrify itself into a witless-giant of Japan from the 1990s? Predictably, both sides of this debate marshal statistics and concatenate.

The inflationist argument is predicated on the effects and dynamics of the massive government bailouts, the monetization of debt and outright addition of liquidity into the economy. In many ways, this is a straightforward textbook causality at play. More insidious are the economic linkages that assist deflationary forces.

The deflationist school has primarily two arguments. The first, simply stated, credit has dried out. As per the International Monetary Research, the loans extended by US banks have been systematically falling - around 14% per annum extrapolated from the most recent three-month data. This is despite the ballooning balance-sheet of the Federal Reserve. The Fed has promised to purchase securities worth around 1.75 trillion USD this year.

Moreover, across the board, various indicators of aggregate money supply have dropped - from M1 (immediately accessible funds) which declined by 6.5% in August to M3 (M1+ time deposits + tradeable short term repo agreements) which declined by 12.2%. Banks are under pressure to improve capital adequacy ratios as expected by the governmental authorities, equity markets and due to corporate risk-averseness. In essence, despite money flowing in – banks are first setting their own house in order.

The second major argument is less esoteric. As per the Case-Shiller index which tracks property prices - real estate in the United States peaked in 2006. Most assets in the long run are mean-reverting after taking into account inflation. To return to the mean, prices have to fall around 40% from the highs. As of July, approximately 32% fall has been recorded. If the mean-reversion theory holds, then another 25% of the fall is yet to occur.

The by-product of this decline is two fold. One, as housing price drops further, leverage will increase - the household debt-to-assets will increase as the denominator declines.

Estimates that the 2/3rd of households in the United States that have mortgages will, on average, have a debt-to-equity ratio of around 100%+. Housing appreciation had led to profit-taking (rents, loans on rising home equity etc) which channeled its way into consumption. However, as housing wealth declines and average debt burden increases – the perceived and real ‘profits' that fed consumption will decline.

Declining credit flow and declining consumer demand are the primary factors that insinuate a deflationary environment. However, the picture is slightly more complex. As per the producer price index, which measures the average change over time in selling prices by American producers, has been rising particularly in heavy manufacturing (aircraft engines and concrete)

However, from a consumer perspective, since rents and wages are rapidly deflating - the story is dire. While the picture is not markedly uniform - the overall impact is that a year on year inflation rate of around -1.4% year has never been seen since 1950s!

There are however two critical unforeseen issues loom large. One, once the Federal Reserve stops or tempers buying Treasuries, it is unclear for how long with foreign governments buy US denominated debt. Is there a point of no-return for US debt market?

Second, as the economy ratchets up its production activity - and particularly banks - and as capital reserve ratios in banks revert back to the mean trends, the money-mulitplier will increase.

So, the 750 billion that are officially in excess reserves that banks hold - and with a multiplier of five, as David Rosenberg estimates - the economy will find 2 trillion dollars chasing goods in a slowly recovering economy.

And lo! Inflation shall emerge. Like everything of value in life, economic recovery will come at a cost.