Tug of War Between Deflation and Inflation

There is an tsunami about to make landfall on the US economy. But will it be inflation or deflation? On the one hand we have deflation propelled by the crushing of commodity markets: oil, gas, gold, etc… as well as the massive real estate implosion across the globe.

On the other hand, consider all the inflationary agents:

• loose US monetary policy the discount rate (as expected) being lowered to 1%
• a loose fiscal policy (in an assumed Obama Biden administration)
• a $1 trillion financial bailout
• IMF bailouts of countries such as Iceland, Pakistan, etc.
• loose monetary policy for all major central banks of the world

To muddy the waters even more, the US dollar has shot up to 2004 levels. Most would argue that a stronger dollar is deflationary. So amid all these cross currents, what can we expect as the net result? I’m not smart enough to wade through all the econometric data so I’ll let the market do that for me.

To get an idea of what the market thinks inflation will be we can look at the difference between the 10 year nominal treasury bonds and TIPS (Treasury Inflation-Protected Securities) which pay a real rate of interest. The difference between them is the forward implied inflation:

For most of 2008 it estimated inflation at 3% but suddenly at the beginning of this month, it went into free fall. As of October 28th, 2009 it stood at -0.2945%. The bond market is clearly expecting the deflationary pressures to win over and win big.

The previous lows on the chart are for June 1998 and February 2001 when the estimate for inflation was 1.44%. Obviously we are in uncharted territory. Something that everyone is used to by now, no matter what metric or indicator we’re talking about. Looking back, in 1998 the Federal reserve reduced the Fed Funds rate from 5.50% to 4.75% by year end. And in 2001, the Fed slashed rates from 6.00% to 1.75%.

The difference with our current scenario is that the Fed had already started reducing rates. The Fed Funds rate was 5.25% way back in mid 2006 so at 1.00% where we currently stand, we are very late in the game. But they don’t have much choice since the other option is deflation.

We could even see the Fed turning Japanese and going for a zero or near zero interest rate. That possibility is more than plausible especially since the Fed’s wording hinted to their readiness to keep cutting. Japan amazingly avoided runaway inflation when they took their rates down to zero from 2001 to 2006.

If only the Fed had listened when the bond market was screaming for a rate cut back in 2007.

Comments

[thedozer:]

3% inflation... how is this calculated?
Feels like I'm paying more than 3% more than I used to...

what is your criteria for calculation? And is this the criteria that lets us know that Social Security is still mathematically solvent?

so this time next year... the fed will pay me to hold its dollars!

2008 Oct 30 11:14 AM

[dieuwer:]

There ain't deflation. Look at the monetary base.
Prices of commodities come down because of supply and demand. Has nothing to do with "deflation".

2008 Oct 30 11:39 AM

[whidbey:]

Too early to make a call. Deflation of assets is to be distinguished from an increase in money supply, maybe a large increase. (Inflation is always and everywhere a monetary phenomenon - Freedman). If we do it right we can have both inflation in money and deflation in asset values. Stagflation. It is likely since that seems to be where things are inclined. If Congress raises taxes we can also have high unemployment concurrently. After that come revolution.

2008 Oct 30 02:34 PM

[jadziasman:]

Shout out to dieuwer,

Ain't deflation? Nothing to do with deflation?

Take a ride out to the Detroit area and experience the fear in person!

Watch the death spiral of at least two of the three domestic auto makers and their supplier base in real time!

Home prices are currently lower in the Detroit area than they were in 2000 with an expectation of further retrenchment to the mid 1990's or earlier.

Detroit is on track to becoming the first major city ghost town. If the taxpayer financed GM-Chrysler-Cerberus-G... "merger" goes through, at least 20% of the homes in the Detroit metro area will be REO's.

If that ain't deflation, what is?

2008 Oct 30 07:57 PM

[dieuwer:]

jadziasman,

Your "Detroit" is a perfect example of supply and demand. Because the big 3 car makers in Detroit are so stupid to make cars that nobody wants, the're going out of business and lay off people.

I suggest you get a job at the Toyota plant. They know how to make cars that sell.

2008 Oct 31 08:36 AM

[EUARTE:]

My memory may be faulty but did not the Japanese suffer about ten years of no growth after to going to near 0 rates?

As for Detroit screw it. Get the Germans in to make cars. Japanese are great but own to much of that industry. It is better to spread it around.

In any deal there should be a big 0 for shareholders. Anyone so stupid to hold these stocks should get what irrational behaviour rewards.

2008 Oct 31 09:09 AM

[carey_jim:]

When we have to pay the Treasury Department, with negative interest rates, to keep our money safe and available, then we will have deflation.

A sign of future deflation that you didn't notice is the trend towards a return to mercantilism or erecting more protective tariffs.

Detroit has not indulged in protective tariffs the way Europe and Japan have.

If the economic crisis gets bad enough, it might happen one day that Americans will circle their wagons and raise the cry "Buy American." Then a fence of protective tariffs would be erected around American cars and it would become unpatriotic to buy a foreign car.

Stranger things have happened before, obviously.

There are rumors that Trabant is building a new factory in Dearborn with money from McDonald's. (The "Trabbi" runs on French Fry cooking oil.)

2008 Oct 31 01:30 PM