Deleverage, Deflation, and the Federal Reserve

Thanks to "Contrary Investor," the following chart further confirms my believe that the deflation through deleveraging will continue throughout 2010. The long-term average from 1980 indicates an average "House Debt as a % of GDP" of 66.4%. Currently, that percentage is approximately 95%. Reversion to the mean, anyone? I, for one, do believe that the reversion will take place, which means that deleveraging still has a long way to go.


Now, what does this mean for Fed monetary policy for the remainder of 2010? Take a look at following table.


Over the last year, the FED has purchased approximately $1.25 trillion of U.S. Treasuries, Mortgage Back Securities (MBS), and Government Agency Securities out of thin air. What is interesting about the FED purchasing $1.25 trillion of "questionable, quality assets, is that the money supply (M2) hardly increased, something like less than $50 billion. What happened? Well, deleveraging occurred. See, when deleveraging occurs, the money supply decreases; because individuals are paying off their debts. When you pay off debt, you write a check; and the money supply decreases by the amount of the check. Or, when banks write off defaulted commercial and consumer loans, money supply also declines. That is why inflation has not been a real problem because of deleveraging. The deflationary factors of deleveraging have exerted a greater influence that the FED's inflationary forces of injecting $1.25 trillion into the economy.

I firmly believe that the FED will provide another mega dose of liquidity into the economy as it tries to reflate the economy this year. The last thing that the FED wants to occur is an outright decrease in the money supply. As long as the FED provides liquidity in its attempt to stem the tide of those deflationary forces, financial assets, especially the stock market, should benefit directly as it did in 2009. The reason being is the liquidity has to go somewhere, because banks are not making loans.