How long will the US credit contraction last?

Will the Fed lower rates to avoid the threat of deflation? Or does the credit contraction still have some way to go? Find out what your investment strategy should be in these times of interest rate uncertainty.

My friend Bill Bonner is an amazing man. He has built the first global newsletter empire, and is acquiring fame as a best-selling author (Financial Reckoning Day, Empire of Debt).

Like me, he's an iconoclast who is comfortable in cultures far from those of his upbringing. He's an American who relocated to provincial France a decade ago, and whose latest personal venture has been to buy a ranch in a remote part of Argentina.

In his newsletter Daily Reckoning ( he recently addressed the question of whether inflation or deflation is now the bigger threat to the US, and therefore to the world, economy.

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Rising bond yields suggest that the great credit boom is over, he argues. Too many Americans have now got themselves too heavily in debt. "They need to pay down their debt, write it off, and work it out. That's what must happen before a new round of credit inflation can begin".

But that could take a decade or more.

Inflation v. deflation: why did the Fed raise interest rates?

"Typically, a credit contraction shrinks everything down with it. Earnings go down. Consumer spending is reduced. GDP growth fails, or even goes negative. And prices for most financial assets dive. The Fed's real enemy is not inflation at all it's deflation.

"Both Bernanke and Greenspan recognized the deflation enemy. And raised rates not to fight inflation (although that is what they appeared to be doing), but to reload the gun.'

"They had to hike rates in order to be able to cut them to fight deflation." Now, with the Fed's short-term interest rate back up at 5 per cent, it has 5 percentage points of interest-cutting potential. The US central bank has rebuilt its stockpile of ammunition.

What will motivate the Fed to start using that firepower?

The most likely signal of deflation is a slowdown in consumer spending. Since consumer incomes are either flat or falling, that spending depends on "the real estate market continuing fat and flourishing. And for that, the housing market must be propped up like a corpse at a viewing.

"The Fed must try to keep house prices from collapsing at any cost! But the housing market depends on long rates, not short rates. Mortgages are long-term debt. And long-term lending rates depend largely on lenders' view on inflation.

"If they think they have a real inflation fighter at the Fed, they are most likely to lend at low rates. If, on the other hand, they see the Fed's knees weakening they're likely to want higher rates.

"This explains why the Fed is still raising rates, even though it sees deflation as the biggest threat. It explains why Ben Bernanke may raise rates again in August he is merely trying to keep housing payments low so the real estate market won't fall apart."

His strategy is to "crush inflationary expectations, while preparing to fight deflation as soon as it appears. When US asset prices crack that is, when stocks, bonds and real estate begin to collapse you will see another rush to cut rates."

Inflation v. deflation: does the credit squeeze have further to go?

However another of my favourite commentators, Donald Coxe, the erudite strategist at Canada's BMO Financial Group, clearly believes that the global credit squeeze still has a lot further to go. "The financial world now faces a drought of unknown intensity and duration," he says.

The Bank of Japan, which manages a monetary base larger than America's, has recently been pursuing "the most deflationary monetary policies of any central bank" since the 1930s Depression.

Despite signs that a global economic slowdown has started, inflation figures are proving "surprisingly stubborn" and therefore the big four central banks (those of the US, the Eurozone, Japan and China) could well "feel they have to keep tightening through winter."

However, he is optimistic that "the next slowdown will be much less painful than the 2001 mini-recession."

The stocks that investors should continue to hold through the current period of central bank contraction are those of companies that deep-pocketed competitors are itching to buy such as exploration and mining companies with long reserve lives in politically-safe countries and enterprises "whose dividend growth at rates higher than inflation will continue in bad times as well as good."

Inflation v. deflation: what should you do now?

Follow David Fuller's advice ( : "We are still navigating the mildly hazardous meteorite zone of economic uncertainty due to interest rate concerns, high oil prices, a degree of mean reversion for the corporate profits of some sectors, and unfavourable seasonal factors."

Consequently the current quarter "remains a time for risk aversion and future planning, rather than aggressive investing or trading My best guess is still that the environment for stock markets will turn favourable by end-October."

Uncertainty about how far central banks will go in pushing up short-term interest rates before they reverse course and try to start another credit boom explains investors' current nervousness.

By MartinSpring in On Target, a private newsletter on global strategy