'D' Is For Dreadful Dreary Deflation

Never before has a word in the financial lexicon been as misunderstood and/or as abused as the word "deflation".

For some reason, capitalizing the first letter of the word makes it all the more misunderstood, even threatening, perhaps due to words such as "dreary", "dreadful", and "disastrous" (to name just a few) that also start with the letter "d", not to mention the poor (but passing) grade that occasionally shows up on report cards for even the best students, a letter "D" that is invariably capitalized.

At the Bureau of Labor Statistics, where the U.S. consumer price data that could be used to prove or disprove the existence "deflation" is kept, an odd change back in 1983 saw the removal of one of the world's most important consumer prices - home prices.

Were that data to be substituted back in (as is done frequently around here), one could argue that we've had either "deflation" or "Deflation" off and on for the last year or so.
When looking at the chart for "core inflation", economists' preferred measure of price changes where energy and food are excluded, it appears as though we've been running in the minus 3 to minus 4 percent for most of the year.
Over in the U.K., the dismal scientists are scribbling furiously in an effort to predict where prices may head next year and whether they should be worried about any sort of "'flation", be it "inflation", "deflation", or "Deflation".

While the idiosyncrasies of British 'flation calculations relative to those in the U.S. are not known to me, it's pretty clear from this report in the Telegraph that some measure of home prices works its way into their price statistics.

Naturally, this begs the question of how the British could have had such a "rip-roaring" bubble in real estate earlier in the decade without setting off all kinds of alarm bells at the central bank.

Since they really seem concerned about "deflation" now, maybe they should follow the American lead of completely excluding home prices - that way you'll never see in-flation or de-flation getting away from you unless the price of rent falls, something that it looks like we'll be able to avoid for years to come, given all the excess housing that exists.

Anyway, they seem to be quite concerned:

Britain faces deflation for first time since 1960
For the first time since 1960, the cost of living will start to shrink next year, in a worrying parallel of the Japanese "disease" of the 1990s, according to new research.
...
The Monetary Policy Committee last week unexpectedly cut rates by a half percentage point to 4.5pc in the face of the financial crisis. However, there is also growing evidence that inflation, which has risen above 5pc in recent months, is set for a dramatic fall. The Retail Price Index – the most comprehensive measure of UK high street prices, will drop at an almost unprecedented rate to -2pc by the second half of next year, according to new research from Fathom Consulting.

It said the fall was largely due to the drop in mortgage costs and house prices, which together form a large part of the RPI. However, lower food and energy prices would also play an important role. Since modern comparable records began in 1956, the RPI has dropped into negative territory only once, in the late 1950s and early 1960s, but it only dropped as far as a rate of -0.5pc.

Andrew Brigden, economist at Fathom Consulting, said: "This does have worrying implications – particularly if it heralded a general period of deflation. The risk is we have a rerun of Japan because you simply can't [cut interest rates] to below zero."

Inflation could potentially drop to as low as minus 3 percent (which would surely be called "deflation", no?) if home prices continue to fall and energy prices remain low.

I'd still like to know how the housing bubble never showed up in their inflation statistics.

Anybody?

Comments

[investor88:]

Tim has put up an excellent article no doubt about it. Article has thrown light on the subject of deflation, a subject not well understood by the average "Joe".

After the tech bubble of 2000, America was facing deflation. The Fed kept lowering rates but the economy was comatose. That was when Helicopter Ben came in, saying that he would drop money from helicopters to deal with deflation. Then Lo and behold, the Fed was able to blow up another bubble, this time the real estate bubble. The real estate bubble became a bigger bubble than the tech bubble. The Fed took the new real estate bubble as permanent properity - with the benefit of hindsight it wasn't of course.

So here we are battling another deflation but this time the Fed may have run out of magic to find another bubble? We may have to return to facing reality and rebuild from there.

2008 Oct 19 05:21 AM

[Ed O in PA:]

I'll admitt I am a bit of a nimrod when it comes to economics. Please explain how lower interest, housing and energy costs are bad for households. Especially fixed income folks. I can speculate that downward pressure on wages could in part be the answer. Comments?

2008 Oct 19 09:10 AM

[User 268734:]

"While the idiosyncrasies of British 'flation calculations relative to those in the U.S. are not known to me, it's pretty clear from this report in the Telegraph that some measure of home prices works its way into their price statistics."

There are two widely used price indices in the UK: the retail price index (RPI), and the consumer price index (CPI). As the Telegraoph article explains, the former incorporates certain housing-related costs, whereas the latter doesn't. The CPI has therefore been consistently lower than the RPI throughout the housing boom. Guess which measure the government prefers to cite and the Bank of England uses for inflation-targeting? Just as the BLS fiddles US inflation figures with hedonics and the like, so the UK authorities like to stuff the CPI full of things that are getting cheaper. So maybe property will soon find its way from the RPI into the CPI for a while.

Essentially, the UK politico-financial complex has been up to exactly the same tricks as the US complex during the cheap credit years: pump up an asset bubble, make people feel richer, artificially suppress the inflation indices, and keep the increasingly indebted consumer spending so that our retal--driven economy looks to be growing strongly. On both sides of the Atlantic, they're up to their old tricks, but this time under the guise of saving the financial system: obscenely loose monetary policies bidding to buy off voters. Talk of deflation is a scare tactic to justify efforts - which will hopefully be unsuccessful - to get another asset bubble going.

2008 Oct 19 11:43 AM

[carey_jim:]

For Ed O in PA:

About inflation-deflation.

First, I'm not a professional economist therefore I feel obligated to lampoon the entire profession.

The American economics profession has retreated to neo-classical (Adam Smith) economics but dressed it up with advanced mathematics so the layman can't understand what they are doing.

I happen to be a trained mathematician and I can understand what they are doing but I can also see (as virtually every NON-neo-classical economist can) that neo-classical economics ("The invisible hand") has no more relevance to the real world than Marxism does. ("To each according to his need, from each according to his ability")

For example, the neo-classics say that inflation and deflation are unimportant because in the long run prices reach equilibrium and everything reverts to what it was before. (They don't mention that in the meantime (the long run) we have all died of natural causes, including starvation.)

I hope that helps ;)

2008 Oct 19 12:47 PM

[Fabien Hug:]

Problem 1 with economists; they think they are smart. I even read an article where one compared his "science" to physics! They are so smart that they sometimes hire physicists and mathematician to solve their problems. It makes them feel smarter.
Problem 2 with economists; money is the nervous system of the economy. You can't avoid them. They are going to stay and keep hiring mathematicians and physicists to build nice models to prove great moderation and the end of risk.

2008 Oct 19 01:47 PM

[Fabien Hug:]

I forgot smth; Mr Iacono, I like your articles.

2008 Oct 19 01:51 PM

[henarl:]

Economists are right up there with alchemists. D also stands for Deleveraging, Depression (both financial and psychological), and Disaster.
It also stands for Deliverance, Destiny and, best of all, Dividends!

2008 Oct 19 05:27 PM

[billp37:]

"'D' Is For Dreadful Dreary Deflation"

"B" is for B.S.

And "R' is for retaliation.

www.prosefights.org/th...

2008 Oct 19 07:32 PM

[VentureJim:]

For Ed O in PA:

By themselves, low interest rates, energy costs, inflation, etc. are very good for fixed income folks... What ruined everything was GREED.. It appears that nobody was satisfied to buy a small house with a reasonable low fixed rate mortgage... If they did, say in 1995, they are still sitting pretty.

However, low rates meant folks could buy bigger homes for just a little larger payment.... And the value of those homes were going up 15 - 20% every year (actually because the rates were kept low..)...

When the Fed buys up these bad mortgages at 60 cents on the dollar, and then auctions the homes off, you will again get a chance to buy a home at below 1995 prices--- if you have decent credit or cash...

hang in there amigo

2008 Oct 19 09:37 PM