Why You Shouldn't Dismiss The Risk Of Deflation

The continued downward spiral of the market's inflation outlook does not bode well for an economy that is supposed to be out of recession. James Picerno writes that is would be a mistake to dismiss the risk of deflation although a strong response by the Fed could quickly reverse momentum. See the following post from The Capital Spectator.

The summer is winding down and so too is the market's outlook for inflation. The 10-year forecast for inflation, based on the yield spread between nominal and inflation-indexed Treasuries, dipped under 1.6% last week—the lowest level in about a year.

That's a disturbing sign for a number of reasons, starting with the recognition that this is supposed to be an economic recovery. The recession technically ended last year, or so many economists opine. If so, inflationary pressures at the very least should be holding steady if not rising. And for a while, that was the trend. Through the end of this past April, inflation expectations were on the march, rising to roughly 2.45%, up from something approximating zero in late-2008, when the financial crisis was raging. But as the chart below reminds, something changed in May and the D risk was on the march once more. The recovery hit a wall of turbulence and the macro outlook has been suffering ever since.



The challenge was compounded earlier this month when the Federal Reserve disappointed the market with a tepid response to deflation's mounting momentum. Since the last FOMC meeting on August 10, the Treasury market's 10-year inflation forecast has fallen by nearly 20 basis points. If the Fed's last FOMC statement was designed to arrest the market's worries about deflation, the effort looks like a failure so far.

But talk is cheap. What of the central bank's actions? Is monetary policy reacting to the rising to the challenge of the D risk? Perhaps. Recent data on monetary aggregates suggest a change may be unfolding as we write. The monetary base (defined by MZM money stock) turned up recently after a period of decline. As the second chart below indicates, MZM has been rising in recent months.



So far, however, the increase in MZM hasn't reversed the year-over-year percentage change. As the next chart shows, MZM's annual pace is still negative, as it's been for most of this year.



No wonder that long Treasuries have been soaring in recent months. The threat of deflation has motivated the crowd to bid up prices on government bonds. The iShares Barclays 20+ Year Treas Bond (TLT), for instance, has climbed nearly 20% since late-April, roughly the start of the current worries over the D risk.



For investors, the burning question is whether the D trade has legs? There's lots of positive momentum to argue in the affirmative. But it'd be a mistake to assume that deflation is a done deal. Yes, the Fed has stumbled and let worries about future prices take a tumble. But the game isn't over. The central bank can still change the market's expectations, but it's going to be harder to gain traction and the clock is ticking. Remember, this is all about managing expectations. Let's not forget that the Fed could, if it was so inclined, push long rates much lower by printing money. There are some very good reasons for why Bernanke and company are reluctant to roll out the nuclear option. But events may be set to overwhelm otherwise cautious thinking on matters of monetary policy.

Meantime, there's quite a bit of risk embedded in the D risk trade, on both sides. It's getting harder to dismiss the possibility that inflation expectations will continue to shrink. At the same time, the easy money in going long government bonds may not be so easy if the Fed chooses to get tough with the deflationary momentum. Since no one is really sure how all this will play out, this is no time to bet the farm, one way or another. We're in uncharted territory. Invest accordingly.

This article has been republished from James Picerno's blog, The Capital Spectator.

Reasons Why Deflation Is Not A Threat

Moses Kim lays out his argument for why deflation is unlikely to hit the US in the near future. He points out that deflationists are missing the mark with their assertion that the dollar will increase in value and are discounting the ability of the government to fight deflation. See the following post from Expected Returns.

Based on the comments and emails I'm receiving lately, it appears more and more people are hopping on the deflation bandwagon. These correspondences have exposed to me an obvious misunderstanding of basic facts. While I suppose I am an "inflationist", I'm the first to admit that deflationists have some valid arguments to support their claims. But at the end of the day, their arguments are flawed; I just don't see deflation as a realistic threat moving forward.

There is a constant tug of war between deflation and inflation that hinges on factors such as money supply, credit, interest rates, and inflation expectations. While these variables push inflation in either direction, there is undoubtedly one variable that swings the odds decisively in either direction, and that is the dollar. There can be no sustainable deflationary trend with a falling dollar any more than there can be an inflationary trend with a rising dollar.

So let's get one thing out of the way. Deflationists are saying that the dollar will rise in value, and based on some of the doomsday asset collapse projections I'm hearing, quite dramatically. Now if this isn't already ridiculous to you, I'll examine some of the factors that will make a sustainable rise in the dollar unlikely. To do this, we must explore the last great deflationary period in the U.S, the Great Depression.

Most people think of the Great Depression as one continuous deflationary collapse- but it wasn't. Broadly speaking, we can break down the Great Depression into 3 stages: 1929-1932, 1933-1937, and 1938-1941. The key period is 1933-1937, for this is when we saw the initial inflationary effects of going off the gold standard.

Below I will present some things to take away from the Great Depression. These factors are critical to understanding why a deflationary collapse is unlikely to occur based on present-day conditions.

Agrarian-Based Society

During the Great Depression, farmers accounted for nearly half of labor. The maturation of the American economy from an agrarian to industrial economy created a staggering level of unemployment, which was deflationary. The Dust Bowl of 1933 obviously exacerbated the problem and put pressure on wages.

However, from 1933-1936, the second phase of the Great Depression, unemployment declined from 25% to 11%. Spending power reappeared, as evidenced by a spike in real final sales. Deflation? I don't think so.



Mass Defaults in Europe/Gold Standard

The 1930's were characterized by mass defaults across Europe stemming from a sovereign debt crisis. Defaults were directly correlated to debt to GDP ratios and the percentage rise in budget deficits in preceding years.

The psyche of Europeans was obviously scarred due to world wars, revolutions, and constant conflicts. As soon as sovereign nations started to default, capital sought safety. The U.S. was one of the few countries that remained on a gold standard, so capital flooded into the U.S. dollar, which for all intents and purposes was as good as gold. So the rise in European defaults activated a temporary flood into the U.S. dollar (aka gold) in 1930-1931, which created the sensation of deflation in America. In effect, the deflationary trend was accelerated by the concentration of capital in U.S. dollars.

1933-1937 Deflation?

As soon as FDR was inaugurated he took us off the gold standard, which immediately devalued the dollar and sparked an inflationary trend. This created a spike in asset values that was most notable in stocks. There was some semblance of a recovery, but it was short-lived because of flawed government intervention. But that's a story for another day.

Anyway, how many deflationists will tell you that CPI rose from 1933-1937? I'm guessing none. But sure, go ahead and listen to the deflationists who take a chart of the Dow in 1931 and plot it against a 2010 chart and predict a stock market collapse. Absolutely. Utterly. Ridiculous.





After collapsing in the early stages of the Great Depression, GDP exploded for the duration of the Great Depression. Now obviously this occurred because of massive government spending. But a good forecaster must account for government intervention; otherwise their analysis is seriously flawed. The fact remains that the government won't idly stand by if there is a massive deflationary episode in the U.S.



Debt Destruction

Deflationists constantly conflate debt destruction with deflation while forgetting one tiny fact: The government has a technology called the printing press. A determined government can easily fight deflation. We already got a glimpse of how the government can counteract the forces of deflation by handing out free money in the form of homebuyer tax credits. The spike in sales of homes spurred by tax credits confirms that you can manipulate behavior by giving out free money. This proves beyond a doubt that a determined government can create price distortions.

The most important point I am going to make is this: The coming inflation will result from a loss of confidence in government. A massive deflationary collapse can only occur if: a) our Federal government resorts to full-scale austerity measures (unlikely); b) Americans hoard dollars (unlikely); and c) there is a rise in the value of the dollar that evidences a rise in confidence in government (impossible).

I urge you to consider the aforementioned arguments and stop listening to deflationists. I will add the caveat that there will be huge moves in the dollar in both directions. In other words, we can experience temporary bouts of deflation. But to predict a drawn-out deflationary collapse is just ludicrous. A 90% decline in stocks is ludicrous. So is a 90% drop in real estate. The odds are heavily tilted against those things happening for the reasons I outlined above. The only real threat is inflation- about this I am sure.

This post has been republished from Moses Kim's blog, Expected Returns.

Consumer Price Index Grows At Fastest Pace Since August 2009

A 0.4% increase in retail sales in July offers a bit of optimism that the economy is growing according to James Picerno. Additionally, the fastest pace of growth for the consumer price index since August 2009 suggests a decrease in deflation risk. See the following post from The Capital Spectator.

Retail sales posted a modest gain in July and consumer prices advanced as well, delivering some much-needed statistical counterpoints to the deflation-is-fate argument of late. But closer inspection of the numbers leaves plenty of room for debate about the economic outlook. Beggars, of course, can't be choosy and so the numbers du jour are welcome if not exactly cause for celebration.

Let’s start with consumer prices. The consumer price index (CPI) rose 0.3% on a seasonally adjusted basis last month. That's the highest pace since August 2009’s 0.4%. For the weekend, at least, it's harder to argue that deflation is upon us. The latest CPI reading translates into a 1.3% rise over the past year. That’s slightly higher than the previous reading, although the rolling 12-month rate of change for CPI still looks weak, as the chart below suggests.

Rolling 12-month % change in headline CPI

After stripping away food and energy prices from CPI—leaving the so-called core rate of inflation that the Federal Reserve targets—the pricing trend looks considerably weaker. Indeed, core CPI rose a mere 0.1% last month, well below headline’s 0.3% gain. And for the past year, seasonally adjusted core CPI is up by just 1.0%--the lowest since the early 1960s.

Rolling 12-month % change in core CPI


It’s tempting to think that inflationary pressures have merely evaporated and that this is good news for the economy. Indeed, something close to stability on the pricing front is every central bank’s goal. But given the current profile of an economy that appears to be struggling to maintain growth, an unusually low level of core inflation raises questions about the potential for deflation if the economy weakens further in the months ahead.

Whatever concerns are suggested via today’s CPI report, anxiety is minimized somewhat by the news for July retail sales. Last month’s 0.4% jump reverses two straight months of declines. Much of the rise, however, is due to strong auto sales last month, which was reportedly driven by one-time incentives for buyers.

More importantly, the 12-month rolling pace of retail sales is still holding up, as the chart below shows. The annual pace of sales is sure to decline in coming months. Year-over-year comparisons look strong at the moment, but that's largely because last year's readings were unusually depressed. The question is how the trend fares from here on out. Much depends on the labor market, which for the moment is suffering from mediocre growth.

At best, July’s economic profile so far is mixed. Meantime, a fair amount of additional data for July is coming during the remainder of this month and so a complete reading is still up for grabs. For instance, next week brings updates on housing starts and industrial production, followed by July figures for durable goods orders the week after.



Meanwhile, retail sales offer a bit of optimism for thinking that the struggle for growth isn’t lost. It's hardly definitive, but it's all we've got for the moment. But after yesterday’s discouraging news on new jobless claims, it’s clear that the macroeconomic outlook is still cloudy.

One retail sales report certainly doesn't render the last several months of sluggish economic news irrelevant. "There is only one thing that's for sure -- economic momentum has slowed," Jennifer Lee, senior economist for BMO Capital Markets, told AP today.

But given the diminished expectations for the future, one could argue that today's numbers are a turn for the better, if only marginally and relative to pessimistic forecasts. "Consumers are still cautious, but it is not double-dip material," opined Stuart Hoffman, chief economist at PNC Financial Services Group, via Reuters.

Such is the realm of "good news" in the new normal.

This article has been republished from James Picerno's blog, The Capital Spectator.

Is The US Currently In Deflation?

Moses Kim from Expected Returns discusses the current inflation taking place in areas of the economy like medicine and college tuition that run counter to the questionable deflation numbers indicated by the government's consumer price index report. He suggests that that the Fed is most concerned about deflation in real estate, because of its potential to result in recession. See the following post from Expected Returns.

I initially planned to address the concerns about deflation in a brief post, but the subject is so complex that I'm afraid I will have to address it in 2 parts. Part 1 will lay out where we currently stand, while part 2 lays out my inflationary argument for the future.

First of all, what is deflation? Is it the contraction of money supply and credit, or is it the general decline of prices? (You know you are in the middle of a controversial debate when people can't even agree on basic definitions). I think we can all agree that economics is useful only to the extent that it explains the real world. Is my standard of living going down? Is food becoming more expensive? Is the government robbing my future by debasing our currency? That being said, I think the best definition for the sake of argument is that deflation is the decline in general price levels.

There are a growing number of investors who are expecting a deflationary collapse in America. Put another way, that believe the dollar will rise in value. I will devote Part 2 of this series to why this is utterly insane. But basically I believe it is impossible to have a long term deflationary trend in a pure fiat system as long as the government is determined to prevent it. Absolutely, positively, 100% impossible.

Let me lay out an undeniable fact for both inflationists and deflationists: We are currently experiencing both inflation and deflation. Home prices and bond yields are falling, but inflation expectations remain elevated. Many other costs are rising as well, with the biggest increases coming in medicine and higher education.

Medical Costs

Medical costs are one of those things you can't avoid. Anyone who has had a serious illness understands how onerous medical costs can be.

The standard defense against rising medical costs is that medical care has improved. Strange, but you never hear these kind of arguments for computers, cell phones, or anything else that is in a steady trajectory of improvement. The fact remains that medical costs have risen in this so-called deflationary environment.



Tuition Costs

I believe higher education is the second biggest bubble I've seen in my life, trailing only U.S. government bonds. Tuition costs have risen to the point where the long-term value of a liberal arts education is very dubious. There is only so long this bubble can last. When people talk about deflation, they certainly aren't talking about tuition costs.



Trusting the CPI?

Many deflationists have a healthy dose of skepticism towards the government. They know the Fed is a private corporation; they understand the statistical joke that is the unemployment rate; and they understand that Social Security is a giant Ponzi scheme. The truly ironic thing is that these same people then turn around and accept the government's CPI figures as gospel. They'll point to a 0.1% decline in the CPI (according to the government) and scream that a deflationary collapse is upon us. Am I the only one who sees the humor in this? Anyone with some knowledge about economic statistics knows that CPI is incredibly flawed.

Anyway, does this look like a deflationary collapse to anyone?



A lot is made of the deflationary tsunami and "lost decade" of Japan. But if you take the time to plot consumer prices during this presumed deflationary collapse, you'll find that consumer prices actually rose. Real estate and stocks, of course, are a different story.



So why all the hoopla about deflation? Well I'll tell you why Helicopter Ben is scared of deflation; it's because of real estate. Do you think Bernanke cares if gas prices go down? What about food prices? Consumer electronics? No, everything hinges on real estate.

I can virtually guarantee a 10% drop in real estate will result in a deep recession. With the ongoing contraction in bank loans, this appears to be a near certainty. For example, banks have only recently imposed standards by which future cash income from a property is not included in present income. This directly contracts the borrowing capabilities of consumers. There are so many factors that are weighing down on housing that explaining it all warrants a post in itself. Without going into specifics for now, let me just say that I am almost positive that home prices nationally will decline again.

The trends present today will determine the trends of the future. Deflation, however tame, leads to inflation.

This article has been republished from Moses Kim's blog, Expected Returns.

Is Deflation A Current Danger?

James Picerno writes that it is critical that the Federal Reserve focus its attention to addressing the real and present danger of deflation, instead of basing its monetary decisions on the potential long-term threat of inflation. Picerno points to the decline of the money supply during the depression which was left unaddressed and resulted in a prolonged depression. See the following post from The Capital Spectator.


The stock market isn't a happy camper. Yesterday's 3% drop in the S&P 500 was a sign that the deflationary worries that revived in May are still considered a real and present danger, including the possibility that the disease may affect the mother of all headline pricing series: GDP. No wonder that with a renewed worry over the D risk, government bonds are hot once more, with rising demand pushing the yield on the benchmark 10-year Note under 3% yesterday for the first time since April 2009.

Much of the discussion is now focused on whether talk of fiscal austerity is to blame for new surge in risk aversion. It's premature to emphasize budget cutting when the economic rebound is tenuous and the labor market has yet to show convincing sounds of durable and sustained growth. This argument can't be dismissed, but the more immediate threat seems to reside in monetary policy.

The annual pace of change has fallen sharply recently for various measures of the money stock in the U.S., from M1 to M2 and MZM. Seasonally adjusted M1, for instance, rose by 3.0% over the past year, based on weekly data through June 14. That's down from nearly 20% a year ago. MZM money supply has suffered an even sharper retreat and was is now in negative territory to the tune of -2.4% vs. the year-earlier reading midway through this month, as the chart below shows.



Is the money supply retreat relevant? Yes, or so a fair reading of economic history strongly suggests. Indeed, it's now been half a century since the publication of Milton Friedman and Anna Schwartz's monumental work A Monetary History of the United States, 1867-1960, which reordered the notion of cause and effect in analyzing the business cycle generally and the Great Depression in particular. The crucial factor is the evidence that the U.S. money stock fell by one-third during 1929-1933—at a time when it should have been rising, or at least holding steady, to offset the deflationary forces ravaging the economy. Summarizing the central bank's colossal error in the 1930s in Capitalism and Freedom, Friedman wrote:

Had the money stock been kept from declining, as it clearly could and should have been, the contraction [in the early 1930s] would have been both shorter and far milder. It might still have been relatively severe by historical standards. But it is literally inconceivable that money income could have declined by over one-half and prices by over one-third in the course of four years if there had been no decline in the stock of money. I know of no severe depression in any country or any time that was not accompanied by a sharp decline in the stock of money and equally of no sharp decline in the stock of money that was not accompanied by a severe depression.

The current Fed chairman Ben Bernanke knows this, of course. As one of the leading authorities on the monetary history of the Great Depression, Bernanke is ideally suited to fight the D risk in the here and now. And to be fair, Bernanke has applied some of those lessons, albeit in fits and starts, in recent monetary policy decisions. Today's economic threat generally is still a fraction of what it was in the early 1930s, and that's largely because macroeconomic wisdom has progressed in some respects. We've learned a lot over the decades, despite what you read. Even Friedman's great insights are just the tip of the iceberg by current standards.

The fact that the target Fed funds rate has been virtually zero for almost 2 years is one sign that the Fed has made at least a partial effort to atone for the institutional sins of the thirties. But as economists like Scott Sumner have been arguing persuasively for some time, monetary policy can and should do more (see here, for instance). In other words, the fact that nominal Fed funds is just about nil isn't necessarily a sign that the central bank is doing all it can to battle the risk of deflation.

Until May, the case that the Fed should do anything more was muted, thanks to the rebound in the appetite for risk. But now there's reason to wonder if Bernanke and company are misreading the economic tea leaves with a misguided monetary policy--a mistake that isn't obvious by looking at the nominal Fed funds rate alone. One recommendation is that the Fed should target a higher inflation target. Yet Bernanke has gone on the record saying that he rejected such a course. In a Wall Street Journal Q&A last December with various bloggers and economists, Brad Delong asked Bernanke: Why haven’t you adopted a [higher] 3% per year inflation target? The Fed head's response:

The public’s understanding of the Federal Reserve’s commitment to price stability helps to anchor inflation expectations and enhances the effectiveness of monetary policy, thereby contributing to stability in both prices and economic activity. Indeed, the longer-run inflation expectations of households and businesses have remained very stable over recent years. The Federal Reserve has not followed the suggestion of some that it pursue a monetary policy strategy aimed at pushing up longer-run inflation expectations. In theory, such an approach could reduce real interest rates and so stimulate spending and output. However, that theoretical argument ignores the risk that such a policy could cause the public to lose confidence in the central bank’s willingness to resist further upward shifts in inflation, and so undermine the effectiveness of monetary policy going forward. The anchoring of inflation expectations is a hard-won success that has been achieved over the course of three decades, and this stability cannot be taken for granted. Therefore, the Federal Reserve’s policy actions as well as its communications have been aimed at keeping inflation expectations firmly anchored.

In short, Bernanke's worried about inflation, or at least he was in December. Is he still worried? It seems so, based on the rapid fall in the annual pace of change in the money stock. To be sure, worrying about inflation isn't a trivial concern, given the inflationary bias of fiat money. It'd be foolish to stop worrying inflation as a general principle. But inflation isn't a pressing concern at the moment, as we discussed yesterday. Yes, inflation will eventually become a concern, and perhaps a big concern, and sooner than the crowd expects, given the mounting debt on the government's balance sheet. And so we need to be ever vigiliant. But that's not the burning issue today, and it probably won't be for the near-term future. Deflation, by contrast, is a real and present danger. It may be a false danger, but it'd be unwise to ignore it at this point, given all the various warning signs bubbling elsewhere in the economy.

The Fed must fight the enemy at its door, rather than focus on the enemy that may attack in the future. And, yes, at some point, the focus will shift from deflation to inflation, at which point the central bank must act aggressively to mop up the excess liquidity. As always, there's a danger that the Fed may mishandle that priority when it arrives. Meantime, it seems to be mishandling the danger du jour.

Is deflation really the priority today? This is economics, and so there's always doubt. The good news is that monetary policy can be adjusted rapidly, in contrast to fiscal policy, which suffers from a number of setbacks that at this point make it look materially less desirable. The idea of waiting for Congress to debate the merits of a new fiscal stimulus, for starters, runs the risk of doing nothing for several months while the economic risk festers. And then there's the debate about fiscal vs. monetary stimulus generally. But we'll leave that topic for later. For now, cranking up the printing presses is practical and compelling today.

Why isn't Bernanke's Fed doing so? Perhaps there's political pressure, or perhaps he has information that suggests deflation isn't the risk that it appears to be. But the clock is ticking and the stakes are rising. If the money stock's rate of change keeps falling, the D risk looks set to rise.

This post has been republished from James Picerno's blog, The Capital Spectator.

The Risk Of Deflation Won't Go Away

With the job creation outlook grim and rate of inflation dropping, some analysts are projecting a double-dip recession with an increasing risk of deflation. The slow money velocity has some calling for an increase in money printing. See the following post from The Capital Spectator.

The Treasury market’s 10-year inflation forecast is slipping…again. That’s no surprise, given the renewed concerns of late on the deflation front (see here and here, for instance). Unsurprising, perhaps, but still troubling.

The inflation outlook dipped to 1.88% yesterday, based on the spread between the nominal and inflation-indexed yields on 10-year Treasuries, according to government numbers. It’s unclear if this is an accurate warning sign that deflationary winds are set to blow stronger, but considering the economic climate of late it’d be short-sighted to dismiss the trend.

As the chart below reminds, the market’s estimate of the inflation outlook slipped below 2% late last month, and it’s remained under that level ever since, save for a few brief but so far fleeting flirtations on the other side. Lower inflation is generally a good thing, of course, but until the economic signals are stronger—particularly in the labor market—the possibility of falling inflation at this point is a sign of trouble.



The jury’s still out on what comes next, but we'll know more in short order. On Thursday, we learn of the latest for the ISM Manufacturing Index, weekly jobless claims and construction spending. A more telling stat arrives on Friday, with the update on the jobs report for June. The headline number on jobs is expected to be negative, but the positive spin is that the trend in private payrolls is expected to show gains. Nothing less is required to counter the weakening outlook on inflation. Indeed, the jobs picture for May was disappointing and the hour is late for convincing the crowd that the labor market has some degree of sustainable upside momentum.

Meantime, the warning signs on monetary policy are becoming too obvious to ignore, according to some analysts. "We're heading towards a double-dip recession," Chris Whalen, head of Institutional Risk Analytics and a former official at the Federal Reserve, told The Telegraph last week. "The party is over from fiscal support. These hard-money men are fighting the last war: they don't recognize that money velocity has slowed and we are going into deflation. The only default option left is to crank up the printing presses again."

Economist Scott Sumner argues that "the Fed suffers from the same sort of paralysis as it did in the Great Depression." It's hard to argue otherwise when looking at the annual rate of change in MZM money supply (M2 money supply less small-denomination time deposits plus institutional money funds). As the chart below shows (courtesy of the St. Louis Fed), the annual rate of change for MZM has turned negative recently for the first time since 1995. Unfortunately, we're not in 1995 anymore.


This post has been republished from James Picerno's blog, The Capital Spectator.

Key Predictors Of Inflation Or Deflation

While inflationists and deflationists can support their arguments with select data about money supply and interest rates, the most important factor to watch, according to Moses Kim, is the dollar exchange rate. A loss in confidence in a currency can happen very quickly, as the Euro has demonstrated, and this can lead to rapid inflation. See the following post from Expected Returns.

The inflation vs deflation debate is one fraught with biases, misnomers, and rigid positions. What I've noticed is that both inflationists and deflationists selectively handpick data to support their respective positions. This is fine and dandy if your goal is to win an argument; but if you want to win as an investor, you must unemotionally interpret data.

If I had to, I could make a convincing argument in either direction since we are seeing both inflationary and deflationary forces. I don't believe there is much debate on this point. However, the successful investor doesn't tell you what is happening right now. The successful investor is constantly trying to foresee future events using a Bayesian approach to investing, incorporating data on an ongoing basis to adjust forecasts if necessary.

Interest Rates

At the very core of the inflation vs deflation debate are interest rates. Unfortunately, most people misunderstand the relationship between interest rates and inflation.

Interest rates are driven primarily by inflation expectations and default risk. This implies that interest rates can both rise and fall with good reason in both inflationary and deflationary environments. In other words, the relationship between interest rates and inflation isn't so simple as to say lower interest rates equals higher inflation or vice versa.

Inflationists will tell you that low interest rates are inherently inflationary. At the very core of this argument is the fact that low interest rates will induce borrowing, and by extension, speculation. To support their argument, they will show you a negatively correlated inflation and interest rate chart like this:



Deflationists will tell you low interest rates not only evidence deflation, but muted inflation expectations. To support their argument, they will show you a positively correlated chart like this:



As you can see, both deflationists and inflationist can point to statistically and historically valid data to support their respective arguments. Unfortunately, both sides are guilty of showing just a snippet of the overall picture. The inflation vs deflation debate is far more complex and goes well beyond just interest rates.

Money Supply and Inflation

Let me preface the following statement by saying I lean heavily towards the Austrian camp. However, there isn't a strong correlation between money supply and inflation in the short-term. This is key to understanding why a hyperinflationary collapse didn't materialize last year when money supply went through the roof.

In the early stages of inflation, money supply often outpaces inflation by many multiples. This was the situation in the Weimar Republic before their hyperinflationary collapse. The following charts taken from Constantino Bresciani-Turronis seminal text about the Weimar hyperinflation, "The Economics of Inflation", makes this relationship clear.






Notice that in the early stages of inflation, money supply outpaced domestic prices, import prices, and the dollar exchange rate. However, the situation in the Weimar Republic quickly deteriorated to the point where money supply, domestic prices, import prices, and the dollar exchange rate had a near perfect correlation. The public lost confidence in their currency and prices essentially "caught up" to money supply.

In 2009, Ben Bernanke cranked up the printing presses and the money supply expanded at an unprecedented clip, yet there was no hyperinflation. Inflationary forces were certainly concentrated in certain sectors, such as stocks, but on a broad scale, inflation was muted.



Recently the trend in money supply has reversed. According to John Williams at shadowstats.com, M3 is contracting at the fastest rate on record. This is an apparent victory for the deflationists, right?

Not so fast.

Dollar Exchange Rate

I believe the number one driving force of inflation moving forward will be the dollar exchange rate; and I believe the the loss of confidence in the monetary system as currently structured will lead the dollar down. History shows that the truly monster currency moves are driven by public confidence.

Remember, it was only a year ago that the Euro was the safe haven currency of choice for investors. The recent collapse in the Euro is correctly blamed on the debt crisis in the PIIG nations. However, the debt problems in the Eurozone were well known for years. The only thing that changed was perception.

Perception is the only thing propping up the U.S. dollar. Europeans thought they could waddle through their debt problems unscathed until, well, they couldn't. Americans are similarly inflicted with the head-in-the-sand disease that ignores large-scale funding problems similar to those seen in Greece. The dollar will continue to profit from safe haven capital flows until, well, it doesn't.

Swings in the dollar, and by extension inflation, will be sudden and dramatic, mirroring the confidence of investors. It will therefore benefit people in both the inflation and deflation camps to rethink their respective false assumptions. The fundamentals for dollar weakness have been in place for some time; it is now time for the market to recognize it.

This post has been republished from Moses Kim's blog, Expected Returns.

Data Suggests Higher Deflation Risk In Months Ahead

Although recent economic data is encouraging, concerns about the risk of deflation appear to be rising. While fundamentals have not changed, it will take more positive economic data and results to reduce investors concerns about global economic trends. See the following from The Capital Spectator for more on this.

Earlier this week we pondered the potential for higher deflation in the months ahead. One of the suggestive clues was the falling inflation forecast as implied by the shrinking spread between the yields on the nominal and inflation-indexed 10-year Treasuries. At the time, the market was priced for inflation at 2.13% for the decade ahead (as of May 18). A mere 48 hours later, the market-based forecast dropped sharply: Treasuries yesterday anticipated inflation at 1.89%--the first reading under 2% since last October.

The Treasury market is subject to all the usual imperfections when it comes to implied forecasts and so we should be cautious in reading too much into any one day's numbers. But this much is clear: the market's perceived risk of deflation is running higher these days. Given the magnitude of the change, we should think twice before dismissing the message. Indeed, as our chart below shows, there's been a sharp deterioration in sentiment this month in the market's inflation outlook. At the end of April, Treasuries expected 10-year inflation on the order of roughly 2.4%, or some 50 basis points higher vs. yesterday's numbers.



A new round of deflationary risk is unwelcome, of course. Although we're still a long way from a sustained decline in prices across the board, it's not too early to consider the hazard anew, as the latest rush into Treasuries suggests. That's a change for the worse relative to recent history. For six months or so, it looked like the deflation threat had been vanquished. It may yet prove to be so. But there are more than trivial doubts arising today.

Ironically, last month witnessed a long-awaited rise in new business loans. For the first time since October 2008, the monthly tally of commercial & industrial loans approved at commercial banks was higher, according to the Federal Reserve. Although the rise was slight, it was a step in the right direction for thinking that the central bank was finally inducing higher levels of lending again in the corporate sector—a necessary step for thinking that the economic expansion was taking root. Indeed, C&I loans were the last major holdout in the recovery over the past year in terms of showing positive change.



But suddenly there's a fresh wave of doubt. The apparent catalyst is Greece and the debt woes of Europe. But these concerns aren't new. In early February, for instance, we observed that the anxiety over debt and deflation was very much in the air. What's changed? Nothing, really, other than the market has reassessed the red ink challenge and decided the fallout may be worse than previously thought. Pricing risk for the threat du jour is invariably an imperfect science, and one subject to revision. That's been working to our advantage over the past year; now it's swinging the other way. Divining the future is a risky business, with the estimates forever in flux.

Meantime, the world awaits more economic data. The numbers that have been supporting the case for growth so far this year are suddenly ancient. The labor market's apparent return to minting new jobs on a net basis now requires a fresh batch of supporting data to fend off deflationary fears. Ditto for thinking that C&I loans are headed higher. In fact, everything may be reassessed in the days and weeks ahead. What's needed to stabilize sentiment and convince the crowd that the glass is half full rather than half empty? New numbers that show that the recent signs of economic growth were more than a statistical blip; more than a dead-cat bounce.

It was always the case that the apparent recovery was going to be tested. The massive slump that was the Great Recession was never going to fade away quickly and seamlessly. Instead, the restoration of growth was going to come in fits and starts, and keep everyone guessing at times. Back in January, considering the year ahead, we asked: "Will the economic rebound build a head of steam that's self sustaining?" Our forecast at the time: "It's going to a close call." That still looks like a reasonable prediction at the moment. Wiping away doubts born of the deepest recession since the 1930s was destined to take time. But as mere mortals, we're all subject to thinking positively when the recent data looks encouraging. We're not likely to make that mistake again any time soon.

The cause of recovery has taken a hit. It's not fatal, but it's not trivial either. For the moment, it's all about sentiment. And, perhaps, the sentiment is wrong. But for now, it takes a card-carrying contrarian to make the case that the optimism of recent months wasn't misplaced.

"The risk is skewed towards deflation right now," Dimitri Delis, fixed income strategist at BMO Capital Markets, warns. Until—and if—we see economic reports to the contrary, risk aversion is the new new thing…again.

This article has been republished from James Picerno's blog, The Capital Spectator.

Despite Massive Liquidity, Inflation Stays Low

After March's very low consumer price growth, some analysts are revisiting the idea of short-term deflation. However, others argue that the massive liquidity that has been injected into the financial system is a much greater concern. See the following post from The Capital Spectator.

Today’s update on consumer prices for March suggests that inflation remains tame. Is it too tame?

Some analysts think so. In fact, worries over deflation are again popping up in economic discussions. Didn’t we thrash the deflation beast last year? Maybe not. One reason for thinking that inflation is the bigger threat in the years ahead is the massive reflation program that’s been job one at the Federal Reserve, aided and abetted by the profligacy of fiscal policy.

Does the ambitious government’s ambitious efforts in money printing since 2008 threaten higher inflation? Not necessarily, opines Paul Davidson, editor of the Journal of Post Keynesian Economics. In his latest book The Keynes Solution, Davidson argues that merely printing money in and of itself isn’t a sure path to higher inflation. Drawing on Keynes, he minimizes the potential threat of inflation and warns against “knee-jerk” reactions for predicting pricing pressures.

Based on today’s CPI report, at least, there are no official signs of rising inflation at present. Consumer prices rose just 0.1% last month, the government reports. That’s up ever so modestly from February’s report of flat prices. For the 12 months through March 2010, CPI advanced by just 2.2%. That's up from the outright deflation in the year-over-year numbers posted for much of 2009. But is deflation again a growing concern? Some analysts think so.

There is a “near-term risk of flipping to deflation given our view that developed economies have not fully healed and consumers are not yet ready to stand on their own two feet,” advises Mihir Worah, manager of the $18 billion Pimco Real Return Fund. As he explained on Pimco’s web site, “to the extent central banks continue their quantitative easing programs then clearly they are once again truncating the deflationary tail and we can anticipate a successful reflation of the economy. But any meaningful inflation should still be a couple of years away.” Asked if the rise of sovereign debt around the world threatens higher inflation or deflation, he responds:

The answer to this depends on the timeframe and on the country in question. In general, there are essentially three ways out for countries that cannot service their debt: The first is to grow their way out of it, the second is to default on their debt, and the third is to inflate their way out of it. Which option is selected is really country- and region-specific.

Countries such as the U.K. and the U.S., which have their own fiscal issues, clearly aren’t going to default on their debt. They issue debt in their own currency and control their own monetary policy. Hence, in the longer term, inflation is a likely solution to deal with their inability to grow their way out of persistent deficits. However, in the eurozone, you’re faced with a very different situation where countries like Greece cannot issue debt in their own currency. They cannot debase their currency, which makes their economy more competitive, and so it is unlikely that they can grow their way out of it. So the only possible outcome (other than an outright default) is fiscal belt-tightening and reduction of input (labor costs) in order to make the goods and services they produce more competitive – and this is deflationary. We are already seeing signs of this. Countries in Europe with the worst fiscal situations that have started the tightening process, like Ireland and Spain, are already showing strong signs of deflation and we expect to see deflation in Greece as well.

To summarize, countries that cannot grow their way out of the problem and do not have their own currency that they can debase are more likely to see deflation. Meanwhile, you should expect to see the opposite effect in countries like the U.S. and U.K., which issue debt in their own currencies.

Worrying about deflation has also crossed the minds over other analysts recently. "We're looking at an economy that's dangerously close to deflation," Ethan Harris, chief economist at Bank of America Merrill Lynch, tells The Wall Street Journal. The D word is also popping up in various spots around the blogosphere. “The Europeans are heading right into the den of a deflationary trap,” according to Roseman Eruptions. “At a time when most of the world is still supporting an economic recovery plan to boost growth following the darkest days of the credit crisis, the Europeans seem bent on fighting inflation.”

Nonetheless, with all the liquidity sloshing around the world, it’s too soon to dismiss inflation as a real if not necessarily present danger. "I don't think we should be complacent about inflation risk,” Fed governor Kevin Warsh said last week. "Inflation expectations will be anchored until they are not."

In fact, some investment strategists are anything but pessimistic about the prospects for the global economy. Ed Yardeni and his research team at Yardeni.com, for instance, advise in a note to clients today that the outlook for a robust rebound—a “V-shaped recovery”—appears to be in the offing. “That’s what industrial commodity prices are predicting again,” they write. “The CRB Raw Industrials Spot Price Index, which is one of our favorite indicators of global economic activity, is rallying again, more than reversing the loss posted earlier this year.” The note goes on to explain,

In a sign the global economy is emerging from its downturn, the value and volume of world trade, along with global production, are up from 2009 lows, and trending higher. The value of trade has turned down, but remains on uptrend. Renewed strength in commodity prices suggests the global recovery remains on track.

At the moment, it seems that we can’t dismiss deflation or inflation as a potential hazard. In the long run, inflation is surely the bigger problem. But in the course of getting from here to there, the road may run through a fresh tussle with deflation. What’s a strategic-minded investor to do? The default approach is considering both sides of the pricing equation and hedging against these twin demons of potential risk. Unless you have an unusually high degree of confidence about the future, it seems prudent to guard against deflation in the near term and inflation further on down the road.

In short, it’s still too early to abandon allocations to Treasuries or to commodities, each of which represent a hedge on inflation and deflation risks, respectively. There are other hedges, of course. One can argue that equities will benefit from inflation as a long-term proposition by way of earnings growth above the rate of general inflation. The precise degree of how to structure such a dual allocation is debatable, of course. But the general concept seems well founded, at least for the moment.

The larger point is that we seem to live in bifurcated world with respect to the outlook on pricing trends. Or as the ETF Database advises, “Forget The Inflation/Deflation Debate: The Real Threat Is Biflation.”

This post has been republished from James Picerno's blog, The Capital Spectator.

Is Deflation Back On The Radar?

According to Bloomberg: "Economists surveyed in the past month expect U.S. consumer prices to fall 0.5 percent this year, the first drop in five decades." In terms of assets like real estate and stocks, your money buys more today than it did a year ago. But instead of worrying about deflation or inflation, Chris Weber explains how you can hedge against both in the following post from Daily Wealth.

One year ago, in the October 1, 2008 issue of the Weber Global Opportunities Report, I used as a title "The Immediate Danger is Deflation."

My view was, to put it briefly, that the world's central banks can try to inflate as much as they can, by creating money and supplying it to banks. But if banks are afraid to lend it out, or are rebuilding their capital base, and if businesses and consumers are afraid to borrow – and rebuilding their own balance sheets, meaning saving more and spending less – then there is not much that central banks can do.

One year later, I am sorry to see no real evidence that things have changed. If anything, consumers are even more afraid to borrow and spend now than they were a year ago. The heightened threat of becoming jobless may have a lot to do with this. Those who borrowed madly in the past are now in a kind of hangover. They are now trying to save more.

The markets themselves are bearing witness to this. If they feared inflation, interest rates would be much higher than they were a year ago. Instead, they are lower. A year ago, the US 10 year T-note yielded almost 4%. Today it yields just 3.17%.

The Commodities Index, CRB, has fallen from 325 to 259 in the same year. Though the Dow Jones has risen sharply since last March, remember that last October 1 it was close to 11,000, not the 9,700 area it is now. London's FTSE is up a bit: from 5,000 to 5,100. But that's just 2%. Japan has fallen from over 11,000 to 9,800.

Nearly every piece of real estate can be purchased for less money today than was the case one year ago. In other words, cash has been king this past year. And that is another way of saying that deflation dangers have still not gone away.

But one area has done better than the rest. Let's turn to precious metals.

One year ago, gold was $860. Now it is $1,042. Silver was $12.30 last September 30. Today it is $17.43.

For my readers who have been with me for years, I know I have been repeating the same mantra for all that time: Have the core of your net worth in a mix of cash and precious metals.

For my new readers, I repeat this, and point out that this approach has saved a lot of money that would otherwise have been lost. Both cash and precious metals buy more than they did one year ago, two years ago, and even farther back. I meant it as a cautious method to conserve money in perilous times, but it has turned out to be pretty much the best approach one could have.

There are those who are absolutely certain that the future will be high and even hyperinflation. There are others equally certain that deflation will be our eventual outcome. To me, it seems like nothing has changed in the 35-plus years I've been in this business. Back when I started out, there were the same arguments, the same certainty on both sides. Only the names of the combatants have changed.

For me, let's just say I'm not smart enough to know what the outcome will be. The only thing on earth that I am absolutely certain of is that I will die; that indeed everyone alive today will one day die. Speaking only for myself, I may die tonight or I may live 50 more years.

Beyond that, I am reasonably certain that history shows that paper money not backed by gold or silver loses value over time. One million dollars 50 years ago was a lot of money. It was even more money 100 years ago. Today, well, it's not chicken feed, but let's say it doesn't buy what it did 50 years ago, or even 20 years ago.

But in terms of assets like stock and property, one million dollars (or euros, etc.) buys more than it did one year ago.

This may just be a temporary development; it may be the start of a new trend. I am not going to bet everything I have on either one or the other. Instead, I've been protecting myself from both. And that's why I have been owning and building cash right along with the precious metals I own.

I have cash in case I am wrong about inflation vaulting the price of gold and silver higher. I have gold and silver in case I am wrong about the value of holding cash. I have tried to protect myself against both inflation and deflation. I own some real estate in case that goes up. It would make sense for me to own some general stocks that would do well if the world economy does well too.

In other words, my watchword has been to protect yourself in case you are wrong: to protect yourself against being hurt by any eventuality. This was my view one year ago, and it remains my view today.

To me, the future is unclear right now. We stand on a kind of knife edge. On one side lies deflation, and on the other inflation. I have tried to hedge myself against both, and yet not be hurt if either happens. The recommended combination of cash and precious metals has not only done well in the past year. It has done well since 2000.

And while I am watching developments every day, I see no reason to change my approach, which has worked so well. Of course, it has worked in the sense that it has given me more money in my net worth than a decade ago. But more important, it has enabled me to sleep well during all that time – a decade which has been very turbulent and disappointing for many if not most. And to me, this gift is priceless.

This post has been republished from Steve Sjuggerud's blog, Daily Wealth.

Deflation Risk Averted But Could Massive Inflation Be Around The Corner?

By creating nearly $4 trillion in new money and credit, representing the largest increase by the American federal government since the country's Civil War, the monetary system has been repaired and deflation is no longer an imminent risk. But a lack of political will and continued annual deficits in excess of $1 trillion through 2016, along with significant pressures in the economy, could likely lead to broad inflation over the next two years, with gold and strategic assets offering potential shelter from the expected storm. Porter Stansberry from Daily Wealth discusses this below.

There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit (debt) expansion, or later as a final and total catastrophe of the currency system involved.
– Ludwig von Mises

For most of 2009, I've had a friendly disagreement with several colleagues who believe a big deflation will be the end result of the 2008 financial crisis.

I knew they were wrong. I knew inflation would become a problem sooner, rather than later. And in the past several months, I've been proven right.

The mortgage and banking collapse of 2007-2009 saw total collateral values collapse between $5 trillion and $10 trillion. The response from our politicians and central bankers was massive: the largest creation of new money in credit since the Civil War.

The Federal Reserve created roughly $2 trillion in additional credit and loaned it against all kinds of dubious collateral, things like Bear Stearns' mortgage book. (There's a handy and simple guide to estimating the Fed's credit quality. The more acronyms in the lending programs, the worse it gets.)

The Federal government responded with a record annual deficit of at least $1.8 trillion. In the second half of 2008, the outstanding federal debt grew by roughly a 40% annualized pace (24% for the entire year). Thus, in only a few months' time, the roots – the money and credit – underlying our economy expanded at a record pace.

In the second half of last year and the first quarter of 2009, the main question in the world's financial markets was: Can the world's government print enough money, fast enough, to forestall a deflationary collapse?

I knew it was no contest. There is no way for an economy to outrun a printing press. The Fed has the power to create an unlimited amount of money or credit and the power to inject that money into the economy in any way it sees fit.

Let's look at the numbers. Let's assume the total collateral damage of the banking crisis turns out to be $5 trillion. Yes, that's a huge hit – roughly half the output of our economy each year. It's the equivalent of sending every American household a bill for $50,000 – due immediately. However, in less than a year, the Feds have already created nearly $4 trillion in new money and credit. The hole in the system has already been plugged. It only took a few months.

The fight between inflation and deflation is over. Deflation was knocked out in the first round.

The big risk is what happens next. Having turned on the presses to save the day, who will have the political clout and the desire to shut them off? Barack Obama's budget calls for annual deficits in excess of $1 trillion for the next eight years. Thus, by the end of this year, not only will all of the damage from the mortgage collapse ($5 trillion) be replaced by new money and credit, there will be significant inflationary pressures in the economy.

The good news in our economy this year, so soon after such a major collapse, means we will certainly have a massive inflation during 2010 and 2011. There's no such thing as a free ride. Bailing out the banks will carry a heavy price for anyone who doesn't have the resources or the knowledge to escape the dollar.

How can you "escape"? First off, make sure you own plenty of gold bullion. I also recommend owning assets that will run higher in an inflationary environment, like vital transportation and energy assets. Also, own some good farmland. Food and land prices will go higher.

Yes, the news is grim... but if you own gold and strategic assets, you'll survive and prosper in the coming inflation.

This article has been republished from Daily Wealth, a contrarian investment analysis and advice site.

Why Deflation Is More Likely Than Inflation

While many fear the possibility of inflation, Alan S. Blinder, Princeton professor and former economic adviser to President Clinton, explains why he is not worried about inflation. He argues that deflation is currently a greater danger. To learn why see the following from Economist's View.

Alan Blinder isn't worried about inflation:

Why Inflation Isn’t the Danger, by Alan S. Blinder, Economic View, NY Times: Some people with hypersensitive sniffers say the whiff of future inflation is in the air. ... Concluding that the Fed is leading us into inflation assumes a degree of incompetence that I simply don’t buy. Let me explain.

First, the clear and present danger, both now and for the next year or two, is not inflation but deflation. ... Core inflation near zero, or even negative, is a live possibility for 2010 or 2011.

Ben S. Bernanke ... and his colleagues have been working overtime to dodge the deflation bullet. To this end, they cut the Fed funds rate to virtually zero last December and have since relied on a variety of extraordinary policies known as quantitative easing to restore the flow of credit. ... But quantitative easing is universally agreed to be weak medicine compared with cutting interest rates. So the Fed is administering a large dose — which is where all those reserves come from.

The mountain of reserves on banks’ balance sheets has, in turn, filled the inflation hawks with apprehension. ... Will the Fed really withdraw all those reserves fast enough as the financial storm abates? If not, we could indeed experience inflation. Although the Fed is not infallible, I’d make three important points:

• The possibilities for error are two-sided. Yes, the Fed might err by withdrawing bank reserves too slowly, thereby leading to higher inflation. But it also might err by withdrawing reserves too quickly, thereby stunting the recovery and leading to deflation. I fail to see why advocates of price stability should worry about one sort of error but not the other.

• The Fed is well aware of the exit problem. It is planning for it... It might miss and produce, say, inflation of 3 percent or 4 percent at the end of the crisis — but not 8 or 10 percent.

• The Fed will start the exit process when the economy is still below full employment and inflation is below target. So some modest rise in inflation will be welcome. The Fed won’t have to clamp down hard.

...But if the inflation outlook is so benign, why have Treasury borrowing rates skyrocketed in the last few months? Is it because markets fear that the Fed will lose control of inflation? I think not. Rising Treasury rates are mainly a return to normalcy.

In January, the markets were expecting about zero inflation over the coming five years, and only about 0.6 percent average inflation over the next decade. The difference between then and now is that markets were in a panicky state in January, braced for financial Armageddon; they have since calmed down.

My conclusion? The markets’ extraordinarily low expected inflation in January was both aberrant and worrisome — not today’s. As long as expected inflation doesn’t rise much further, you should find something else to worry about. Unfortunately, choices abound.

This post can also be read at Economist's View.

Why Hyperinflation Is Unlikely

While there have been concerns about hyperinflation of late, there hasn't been much evidence of actual inflation. Tim Iacono from The Mess That Greenspan Made argues that we will probably never see an annual double-digit inflation rate. See the following article to find out why.

Some looked at the inflation statistics released by the Labor Department earlier today and said, "See? Deflation is here!"

Others looked at the same set of price data and replied, "See? Inflation is stirring".

They can't both be right, but they can both be wrong (or at least early).

The annual rate of inflation, measured against the price level of May 2008 (back when gasoline and other commodity prices were soaring), came in at less than minus one percent causing deflationists around the world to rejoice, yet stop short of getting out the bubbly.

Why?

Because, so far, this deflation is the Japanese variety, a wimpy version of the much more serious double-digit deflation as seen in the 1930s which, unfortunately, most deflationists fail to understand is no longer within the realm of the possible, unless of course we go back to something like a gold standard instead of printing up new money by the trillions of dollars to replace the dollars that are being vaporized in the ongoing waves of credit destruction.

Then again, since the Consumer Price Index has been effectively neutered by a 25 percent weighting of owners equivalent rent that, while purportedly representing homeownership costs, instead serves to dampen reported inflation. No matter what home prices or mortgage payments do, owners equivalent rent always seems to rise at an annual rate of two percent (even when home prices are falling by ten times that amount) serving as an anchor on the government inflation data.

Due to owners' equivalent rent, the U.S. may never see another double-digit annual rate of inflation - positive or negative.

These days, as far as government reported inflation is concerned, it's all about energy prices and, there, those seeing deflation have something to look at.



Most of the year-over-year change in the overall consumer price index is either directly or indirectly related to the energy price peak last summer and comparisons to it, serving to distort whatever meaning the price index still contains.

But, the intriguing aspect of this morning's report on consumer prices is that you can see in-flation in the data too. After all, gasoline prices have soared more than 70 percent from about six months ago demonstrating the very real difference between $35 a barrel oil and the much more dear $70 type.

Inflationists (and the much more rabid "hyper-inflationists") look at this recent rise in energy prices and figure it to be a sure sign of things to come, what with all the government money printing that has occurred lately - a lot of the newly printed money seems to be going into the black goo.



Anything that doubles in price over a six month period should grab your attention and, whether or not crude oil prices remain lofty in the months ahead is anything but assured, but it's important to remember that present day oil prices are still more than 200 percent higher than the average of the last few decades.

That was the era of modest inflation that many people naively think we're about to return to.

But, that period was really just a fluke.

Never again will the world have cheap, plentiful oil at the same time that clothes, electronics, and other goods are produced at cut-rate prices in the East, only to be sold in the West, and subsequently included in the West's inflation data.

Those seeing inflation in today's data see a world where prices are very different than they were in the latter years of the 20th century, the late-2008 plunge in prices being just a temporary setback to the inevitable higher prices to come.

In the scheme of things, what happened from early-2008 to early-2009 will probably prove to be quite irrelevant - either a blip that quickly fades from memory or a blip that is eventually dwarfed by other much larger blips.

It's way too early to tell.

However, what is quite easy to discern after the last year or so of price data, is that we've entered a very different world of consumer prices and even owners' equivalent rent may not be able to dampen the effects of the price moves in the years ahead.

We probably won't know for sure until sometime in 2010 whether we'll get debilitating deflation or hyper-inflation, though both remain unlikely, at least in my view.

The current inflation numbers are largely meaningless and anyone who reads too much into them does so at their own peril.

This post can also be viewed on themessthatgreenspanmade.blogspot.com.

Should Historic Deflation In Britain Be A Concern?

Could deflation be the next big road block on the road to economic recovery? News out of Britain indicates that significant deflation has hit Britain's economy which can lead to things getting worse rather than better. What does the lowest Retail Price Index since they started keeping records mean for Britain's economy? Tim Iacono from the blog The Mess That Greenspan Made, shares his view on the significance of record deflation in Britain.

The British have succumbed to the scourge of deflation and about all the rest of the world can do now is bid them a fond farewell - they've entered the abyss, as reported by the Telegraph.

Britain sinks into deepest deflation since 1948
The British economy sank deeper into deflation last month to the lowest level in more than 60 years as the effect of falling house prices and lower mortgage repayments escalated.

Inflation on the Retail Prices Index (RPI) measure, which includes housing costs, dropped sharply to -1.2pc in the year to April, from -0.4pc in March, the Office for National Statistics (ONS) said on Tuesday.

It was the lowest RPI figure since records began in 1948, and weaker than economists had expected.

The number of times that economists have been taken by surprise over the last few years has been increasing at such an astonishing rate that, sometimes, you have to stop and wonder why we even keep them around.

Maybe we'd be better off with no forecasts and no expectations for the future at all.

More importantly, you have to wonder why their counsel continues to be sought in order to remedy the ills that took them by such great surprise.

Anyway, on the subject of de-flation, the British method of measuring the changes to consumer prices appears to be even more dysfunctional than the one used in the U.S. as central bank lending rates have a direct impact on their broadest measure of inflation which happens to include interest paid via mortgage payments.

So, all other things being equal, if interest rates are slashed, inflation goes down, whereas, if the bank hikes lending rates, inflation goes up.

The main driver of the fall was lower mortgage interest payments following the Bank of England's decision to cut interest rates by half a percentage point to 0.5pc in March, the ONS said.
...
Although in the short term falling prices will appeal to consumers, RPI is used to calculate wage increases so the sharp fall in April is likely to add to downward pressure on salaries already caused by higher unemployment and falling corporate profits.
"As a result, many workers are likely to get wage freezes or even pay cuts," said Howard Archer, chief UK economist at IHS Global Insight.

Deflation poses a further threat to the economy if people expect prices to fall further and put purchasing plans on hold which can, if the trend persists, lead to lower output and even more job losses.

There's the real evil of inflation - right there in that last paragraph...

If people see negative numbers showing up in the government's measure of inflation, they'll stop obsessing about the ongoing financial market meltdown and how it must ultimately lead to the end of life as we've known it and promptly cut back on their already sharply curtailed spending plans in hopes of getting a better deal sometime in the months ahead.

This post can also be viewed on themessthatgreenspanmade.blogspot.com.