Throughout most of 2014, economists were convinced that the threat
of deflation had been successfully bypassed thanks to Fed intervention. Indeed, many celebrated economic forecasters
have been loudly cheering the mostly solid-looking economic data throughout
most of this year. But as Yogi Berra
once said, “It ain’t over ‘til it’s over.”
The Kress 60-year cycle of inflation and deflation, known as the
Super Economic Cycle, was scheduled to bottom this October. The bottom of the cycle may well be in, but
the deflationary pressure it has helped create hasn’t bottomed yet. If the downward spiral of commodity prices
generated by the final “hard down” phase of the cycle this summer and fall
isn’t reversed soon, we may end up seeing “Revenge of the Kress Cycle” coming
to a theater near you.
Put another way, the incessant meddling and intervention by the
U.S. Federal Reserve in recent years may have staved off the deflationary
impact of the final years of the 60-year cycle after the credit crash. But as Mr. Kress himself was wont to say, “The
Fed ultimately can’t beat Mother Nature and Father Time.” The years of artificial suppressing the
natural cycle of deflation may have created a cyclical backlash, a counter-wave
if you will, that could witness a confluence of falling prices across several
major financial markets around the world.
There have definitely been premonitions of such a deflationary
backlash in just the last few weeks. One
of the most conspicuous of proofs that deflationary currents are at play is the
drastic decline in petroleum prices.
Consider that gasoline prices have been plunging and are now at their
lowest level in almost four years.
Since oil and gas prices are among the most important variables in
determining prices of all sorts of goods, it stands to reason that as oil
prices fall it will eventually lower prices on the retail level. It has long been the observation of top cycle
analysts that a failure of the oil price to decline in a meaningful fashion
before long-term deflation reaches its nadir would do irreparable damage to the
economy once the next long-term inflation cycle kicks off. If retails prices enter a renewed inflation
cycle at a high level, the return of cyclical inflationary pressures down the
line will only serve to strain the economy in the form of higher living
costs. Seen from this perspective, the
plunge in oil and gas prices is a blessing in disguise.
Oil
isn’t the only major commodity to suffer the ravages of deflation. Prices for a large basket of commodities have
continued to slide in recent months. The
Dow Jones Commodity Index has fallen over 10% year-to-date since commodities
peaked in late June. Most losses to
commodity prices have come since then, which corresponds to the final descent
of the Kress cycle. Falling demand and
prices for commodities has hurt countries which rely heavily on industrial
exports, including China and many European countries.
Europe’s
economic powerhouse Germany, for instance, has been particularly hard hit by
the sanctions imposed upon Russia in the wake of the Ukraine crisis. Manufacturing orders for Germany dropped 5.7%
in August, which is the lowest level in over a year. The country’s industrial production plunged
4.3% in August to the lowest reading since January 2013, according to Ed
Yardeni.
In
the wake of these recent developments, economists have modified their forecasts
and are predicting deflation in the euro zone as EU monetary policy remains
tight. ECB president Mario Draghi has
made attempts at raising prices by hinting at a U.S. Fed-style QE initiative,
but so far his plans have been stymied as policy makers in Germany refuse to
endorse it. For now the European Union
remains mired in an economic malaise with no stimulus effort on the immediate
horizon.
Assuming Mr. Kress’s dictum that “the cycles will always prevail”
is true, let’s examine some possible scenarios for the final resolution of the
long-term deflationary cycle. The first
possibility is that of a Kress cycle compression. Simply stated, this scenario would mean that
most of the deflationary damage has already been done and that the short-term
will only witness some residual damage, followed by gradual recovery in equity
prices as well as oil prices.
The next possibility is that of a Kress cycle inversion. An “inversion” is a term used by Mr. Kress to
describe what happens on rare occasions when a major cycle bottom essentially transforms
into a top, leading to an extended decline beyond the time frame of the
original cycle. An example of this was
seen in the final stage of the credit crash of late 2008. While the worst of the damage was seen in the
third and fourth quarters of 2008 when the 6-year Kress cycle was bottoming,
there was additional spillover damage into the first quarter of 2009 before
stock and commodity prices put in their final lows. The (temporary) failure of the 6-year cycle
bottom to reverse the downside momentum in late 2008 was due to a lack of
confidence among market participants. It
took reassurance from the Fed and from Washington in the form of massive
stimulus before investors felt confident enough to commit to buying once
again.
Currently, investors are perhaps waiting for the U.S. elections next
month before making major commitments in the financial market. Meanwhile, foreign investors aren’t budging
until they see the promised stimulus efforts from Europe’s central bankers and
policy makers. If this “wait-and-see”
attitude persists it could give credence to another Kress cycle inversion, just
as it did in 2008.
The market may also be waiting to see if the Fed reverses course
on its stated intention of raising interest rates sometime next year and
instead introduces more stimulus measures if the deflationary pressure
continues. Certainly much more in the
way of stimulus is expected of Europe’s and Japan’s central banks, and
aggressive policy actions from both regions will likely be seen in the coming
months.
Meanwhile there is a growing realization on Wall Street that
perhaps the winding down of the Fed’s quantitative easing initiative was
premature. If the Kress cycle inversion
scenario is realized and prices continue to slide, the Fed will be confronted
with the possibility that emergency stimulus measures are needed to reverse the
damage and prevent full-blown deflation.
If recent market developments have done nothing else, they have
proven the celebrations of economists and pundits over the “death of deflation”
to be woefully premature. Before the
Fed’s vision of a return to “normal” inflation can be realized, it’s clear that
more work lies ahead.
