Deflation Is Mostly Behind Us 18 comments
January 19, 2009
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The consumer price index fell 5 months in a row, from August through December. December's decline of 0.7% was actually a bit less than the market's -0.9% forecast, and the great bulk of all the declines was due to a collapse in energy prices. With oil no longer falling (in fact, Arab Light crude is unchanged for the past two months and higher today than its December average), and gasoline prices at the pump up about 12% from the end of December, it's a good bet that we've seen the end of consumer price deflation. Core inflation has moderated a bit, but remains positive.In contrast, the market (as defined by the difference between Treasury yields and TIPS yields, and as implied in the extremely low level of Treasury yields) is expecting the CPI to be negative for at least the next few years. (Clarification: when I say we've seen the end of monthly declines in the CPI, I'm not talking about the year over year change in the CPI, which is likely to become significantly negative for the next 6-7 months. The TIPS market is ruled by monthly changes in the CPI, not year over year changes.) That's a pretty radical forecast, in my view, considering that monetary policy is massively accommodative all over the world, gold is still well above $800, and commodities as well as energy appear to have bottomed and are now rising.
This means that the market is extremely vulnerable to any signs of an economic rebound, and / or any signs that the overall price level is not declining on a month-to-month basis. Good news, of the kind that would surprise the market and cause equity prices to rise and Treasury bond prices to fall, only has to be "not terrible." That's how bad the pricing is, and how attractive the valuations are in today's market.
So I think the equity market remains extremely attractive, and TIPS, despite their rally since I recommended them a month or two ago, are also attractive. TIPS have been in the dumps for awhile, because who wants inflation-indexed bonds if you expect inflation to be negative? As I noted a month ago here, the end of monthly deflation would be very good news for TIPS, and indeed the prospect of that has led savvy traders to bid their prices up recently. There's still plenty of room for improvement, especially at the front end of the TIPS yield curve, since the curve is significantly inverted (short-dated real yields are higher than long-dated real yields). If the market started to lose its obsession with deflation, then TIPS would become much more attractive and their real yields would fall, while Treasury yields would likely rise.
Full disclosure: I am long TIPS bonds and long TIP.
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I have no doubt that inflation will pick up eventually, but at this point it looks to me like the process will take years and not months.
As long as people worry about their jobs and economic future they will save more. That may not be a bad thing in the longer term. We just must suffer the pain of contraction for some time. Fed and Treasury inflation can not make up for the decrease in incomes and the wealth destruction that has already occurred.
$1-2 trillion can't make up for the $10-15 trillion in paper wealth that has disintegrated out of the housing market and stock markets with more on the way. Especially when most of the money is going to pay off bad bank loans and derivatives. These payments only help banks stay afloat and pay their bills and keep employees for the time being. They don't lead to increased lending or to increased employment.
So I am on the deflation side of the argument still. Inflation can pick up again and destructive government spending can lead to very bad inflation when it occurs. So it is always good to be wary about inflation, but don't bet on some acceleration of it at this point in time.
Politicians, especially Socialists, enjoy inflation as it covers up their mistakes. Not being a Prophet, when the inflation starts is not a question. Consequently, when does the prudent investor prepare for it? We certainly know the "markets" certainly are not the the discounting mechanism many believe, to their own chagrin.
Politicians, also, are slow to take away the false confidence that the beginning of inflation gives markets, business and consumers. Therefore, they wait too long to take away the punch bowl for political purposes. History has proven this, especially the "Guns and Butter" of the sixties which lead to inflation then stagflation. Hopefully we have learned something from that period but I wouldn't put a lot of confidence in that.
The bill will have to be paid and debasing the currency is the most politically expedient.
www.bankofengland.co.u...
On Jan 19 05:52 AM constructe wrote:
> There is no real proof that deflation is behind us or is likely to
> be anytime soon. On the contrary, there is considerable proof to
> the contrary as wages are now shrinking and unemployment is accelerating.
> This will suck more out of the equation of how much is available
> to spend and how much will be spent.
>
> As long as people worry about their jobs and economic future they
> will save more. That may not be a bad thing in the longer term. We
> just must suffer the pain of contraction for some time. Fed and Treasury
> inflation can not make up for the decrease in incomes and the wealth
> destruction that has already occurred.
>
> $1-2 trillion can't make up for the $10-15 trillion in paper wealth
> that has disintegrated out of the housing market and stock markets
> with more on the way. Especially when most of the money is going
> to pay off bad bank loans and derivatives. These payments only help
> banks stay afloat and pay their bills and keep employees for the
> time being. They don't lead to increased lending or to increased
> employment.
>
> So I am on the deflation side of the argument still. Inflation can
> pick up again and destructive government spending can lead to very
> bad inflation when it occurs. So it is always good to be wary about
> inflation, but don't bet on some acceleration of it at this point
> in time.
I DON'T THINK SO!!
Asset deflation has slowed, but could easily fall farther.
What about service prices?
We are not only not buying 'things', we also are not using services.
With services being the larger part of the economy, a second leg down
in consumer spending is coming!
Please be patient, this deflating of the credit bubble has to happen!!
I agree that any pause in the bad news could lead to an equities rally. There is a huge amount of cash on the sidelines, thin trading conditions, and poor returns in bonds. So a bear market rally is possible but we missed the window for it in January. look to the end of earnings season for the next opportunity.
How long do you deflationists think it would take the Fed to "create" the trillions of dollars necessary to overcome what has been lost in asset deflation? About a nanosecond!
In a paper money economy, long-term deflation simply cannot exist. The monetary authorities will overwhelm deflation with inflation and a weakening currency.
When the overly bleak perception changes, the many good credits who are non-leveraged, including some of our best corporations, will be lined up to borrow.
They won't be buying the toys, too-big housing, and other non-income producing junk, however.
They will deploy the money into acquisitions and accelerate a necessary process. In spite of Congress, they will put capital with industries which create wealth. Even if job creation does not accelerate at the same pace, public pension plans will reinflate and take enormous heat off of taxpayers.
In short, as soon as people catch their breath, this economy will snap back, although not necessarily to the benefit of losers. Because the press looks backwards, it will miss the story, of course, until it has happened.
LordD
I am having a problem with the above statement. It makes the money supply/rising prices connection seem predictable and controllable when it is not. I believe such a correlation also is not a historical fact at all. Though rising prices and money supply have often been correlated, as often they have not. Certain economies at certain times, i. e. hyperinflation, yes the connection is clear.
But the causation during more stable inflationary times is much clearer in the exact reverse of what you claim.
For example, since money is created when banks write loans, higher prices will necessarily cause loan amounts to be greater, and therefore money supply creation to also be greater.
This would explain why the high price inflation of the 1970's and growth in money supply then correlate. It was the higher prices causing the increased money supply, not the other way around.
Other periods with more stable or slightly rising prices do not correlate much to money supply growth.
On Jan 19 10:34 AM John Polomny wrote:
> Yes there is inflation, MZM, True Money Supply, M2, M3 (as calculated
> by John Williams at shadow stats) are all increasing. Inflation is
> an increase in the money supply. CPI declines because of a collapse
> in energy prices is not deflation. It is a historical fact that the
> central banks can create inflation that will manifest in rising prices.
> read Mervyn Kings paper "No money, No inflation" for an explanation.
> In his article and the charts provided he shows the time lags involved
> in the process of inflation manifesting in higher prices..
>
> www.bankofengland.co.u...
>
>
>
> On Jan 19 05:52 AM constructe wrote:
...I wouldn't want this CNBC wannabe managing my money!
--Fred Voetsch
On Jan 19 02:44 PM freddyv wrote:
> One only needs to read this man's other articles to see his incredible
> lack of objectivity and reality - seekingalpha.com/autho...
>
>
> ...I wouldn't want this CNBC wannabe managing my money!
>
> --Fred Voetsch
Yes, inflation will return some day, but nobody knows when. I think TIPs are a good buy, but so does everybody, which scares me. Everybody thinks municipal bonds are a great buy, and have done so for 2-3 months. So why haven't they risen? Could it be because many cities may default on this stuff? And if they do, there is no collateral - only default swaps. Can the mono-lines cover a wave of defaults?
Remember in 2007, that 'everybody' said we should diversify into uncorrelated assets like foreign stocks and commodities, especially because 'everybody' knew that the dollar had nowhere to go but down. that worked well in 2008, didn't it?
In 2000, 'everybody' thought that this time was different, and stocks would go up forever. Now in 2008 we are getting a consensus that this time things are not different, that the government and technology will save us, that economic growth will return fairly soon (God's law of capitalism), and so will inflation. The stock market will recover, because it always has. Did Rome have a stock exchange?
Think independently people. The last year really has been different from the post- WWII era. It looks a lot like the 1930's and post-1990 Japan with new wrinkles that matter. The debt bubble this time was worse than the 1930's. It's global. The populations of the developed economies (and China) are aging rapidly. Oil really is running out, and there are alternatives, but this time there are no cheaper alternatives. (The beauty of oil was that it required so little human energy input to produce vast amounts of energy that we could utilize to our benefit.) Global warming cannot be stopped, and can only be slowed by the immediate cessation of fossil fuel consumption. Of course, we don't know the consequences of warming, but it will require expensive adjustments. It's the rainfall consequences that matter most, although we may lose a few coastal cities.
So, beware of conventional opinion. Entertain the possibility that economic growth is not God-given. Large areas of the world in the past have experienced economic decline (and population decline) for centuries. Sustainable economic growth in the form that we have known it is logically not possible. There are no guarantees that innovation will always provide cheaper alternatives to the resources that we have used up and can't recycle. We don't have to worry too much about innovation increasing food production to keep up with population growth, because world population growth will probably cease by the middle of the century - that's not good for economic growth either.
Humans are evolved to be optimistic by nature, because if you're not, you don't survive long enough to ensure the continuation of your pessimism genes. But look at both sides of reality, and look back further in history than the last 200 years, and you must admit to the possibility that things won't get better, at least for quite a long time. So don't buy-and-hold. Trade to survive, lower your living standards while you can make the choice, and don't expect a comfortable/wealthy retirement. Hell, have a good time now, and forget about retirement. I've been retired for 7 years, and would be content to be poor, except I still have a teenager at home, and a wife who would not be content to be poor.