The Deflation That Wasn't

The economy contracted at a 6.1% annual pace in the first quarter, more than expected. The contraction was driven mainly by a huge inventory drawdown, which in turn was a reaction by business to the big slump in spending in the prior quarter. That will almost certainly turn around for the better in the current quarter, because spending is now growing again—real consumer spending rose at a 2.2% rate in the first quarter, and all the green shoots out there confirm that activity is bouncing in many areas of the economy.

The big news for me, however, was the 2.8% annualized rise in the GDP deflator, which is the broadest gauge of inflation. The chart above shows the year over year change in the deflator, and as you can see, there's not a lot going on, with inflation today about where it has been on average since the early 1990s.

This is one of those "dogs that didn't bark," because conventional wisdom says that the huge (6.2% annualized) contraction in GDP over the past six months should have produced at least a little bit of deflation. That inflation is instead still alive and well is big news, because it says the conventional view of inflation is wrong. Inflation is not, as most people think, a function of the strength of the economy, but rather, as Milton Friedman says, a monetary phenomenon. Money has not been tight enough in recent years to bring inflation down. Since monetary policy is now quite accommodative, we should expect to see inflation drifting higher over the course of the year. This runs counter to what the market and the Fed are expecting, and that could easily overshadow the economy's likely recovery.

TIPS still offer good protection against higher-than-expected inflation, since they are priced to the assumption that inflation will be much lower than average over the next several years. Treasury bond yields, on the other hand, are going to be under tremendous pressure to rise.

Full disclosure: I am long TIP and TIPS, and long TBT at the time of this writing.

Comments

[conceptwizard]

How does a 30% retraction in home pricing factor into this. I guess I sufferd an imaginary loss. How come vehicle prices are 20% lower? Which makes my trade in worth nothing.

2009 Apr 29 03:25 PM

[RiskReturnOptimizer]

This biggest news today should have been the PCE deflator, not headline -6% GDP. 10-year treasury finally broke 3.0% technical resistance, and with Fed making no new QE comments, the next stop is likely 3.5%. Long TBT is best way to play the reflation environment.

2009 Apr 29 03:30 PM

[John Polomny]

That 30% is asset price deflation not monetary deflation. The main problem in the inflation/deflation debate is the failure to properly define terms.


On Apr 29 03:25 PM conceptwizard wrote:

> How does a 30% retraction in home pricing factor into this. I guess
> I sufferd an imaginary loss. How come vehicle prices are 20% lower?
> Which makes my trade in worth nothing.

2009 Apr 29 04:40 PM

[Economic Philosopher]

Good point John Polomny. The GDP deflator also includes only new, domestically produced goods and services which would rule out most home prices, used cars, and other assets.

2009 Apr 29 06:30 PM

[austrian63]

Great article. The whole deflation debate has centered around asset price "deflation" which really is asset prices that had risen well above sustainable levels based on increased money supply. Most "consumer" goods especially food prices have not fallen but instead risen quite steadily due to growth in the money supply (inflation).

We have to remember that money is merely a medium of exchange and the more of this medium that is created, especially out of thin air, the less each monetary unit is worth. The creation of additional monetary units does not increase the wealth of society as a whole but it provide the lucky recipients of the new money a means to bid up the prices of scarce resources. It will be interesting to see the impact of all of the "new" money on prices over the next few years.

2009 Apr 29 07:02 PM

[Tony Daltorio]

I still believe that the whole deflation scare was just something cooked up by the Fed,Treasury, and Wall Street to panic some "suckers" into buying Treasuries at near zero interest rates. Inflation is the train that is barreling down the tracks.

2009 Apr 30 10:28 AM

[Gregman2]

Care to distinguish the term 'deflation' from the term 'disinflation'?;-)

2009 Apr 30 11:26 AM

[LKofScotland]

sure--deflation is what happens when the air is let out of your tire. disinflation is like "disinclination" as in--"yes, i'd like to raise your prices just as much as i'd like to go out with you on a date--however due to the fact that you are (insert scary phrase like "you're ugly" or "you're too poor for me to raise prices") i am "disinflated." (as opposed to those bastard oil and food people who have pricing power and simply raise prices to accomdate their need for more capital.) good article, by the way. simple and to the point. i'd be long consumer staples and avoid the tips because the largest component of inflation is labor and wage rates haven't move in a generation. the pricing power of a bic mac, however, still hasn't budged. the economist magazine's "big mac index" is still the best gauge of determined relative value on planet earth. currencies are far more "in whack" than they were one year ago (the canadian dollar at parity with the US dollar!) but there are still dislocations. for example, diesel fuel is still more expensive than gasoline. this can only be explained by problems in the currency markets which still need further corrections. go long the dollar versus the euro. i predict parity in that exchange rate by summer's (and that's not Larry Summers, by the way) end.

2009 May 01 12:35 AM