The Short Term Case for Long Term Deflation

Jun.16.09 | About: iShares 20+ (TLT)

Co-Written by Lorn Davis

At Portfolio Asset Management we see the current short-term deflation leading to longer-term inflation. While we think inflation is inevitable, let’s drill down on the argument that long term deflationists are making and extrapolate from there. For inflation bulls, it is good to know what the other side’s arguments are, and for deflation bulls, we’re going to tell you what you want to hear! Of course we won’t know for sure who is right for another couple years.

We begin with Friedman’s view that money determines nominal income with a lagging period of 5-22 months. This is important because of Wall St.’s worry about the Fed’s recent quantitative easing and injection of capital. So far the increase in reserves has largely sat in the banks doing little to promote lending. That’s why we’ve seen the steady march in mortgage rates over the past few months to 5.5% and higher. Meaning, the banks really don’t want to lend it all out, or can’t find decent people to lend to. It’s our belief that rates have peaked for the short term with the 10-year treasury at 4% this week.

In addition, Friedman said that the monetary base determined nominal income, not prices. With a weakened labor force we should see increased output as opposed to higher wages. This has happened recently. Of course higher wages would lead to higher prices and ultimately core price inflation. So even though payroll reports are showing “slowing” unemployment, the fact of the matter is the work force is deteriorating at a rapid rate and those with jobs aren’t seeing any raises.

To complement the increasing unemployment rate, last week’s Beige Book told us that “labor market conditions continued to be weak across the country, with wages generally remaining flat or falling.” This is our short term deflationary pressure, wages falling around the country and leading to falling prices. Of course the deflation-bulls ascribe to Friedman’s belief in the time lag between income and the Fed’s quantitative easing to be on the tail end of estimates. Effectively, we won’t see relief for at least half a year or more. In the mean time we’ll be in a state of core price deflation as the stock market continues to putter around demonstrating the lack of economic growth and capital circulation.

The bottom line is we will not see the wage/price spiral until at least next year. Now, long-term, you can extrapolate and say banks will not start loose lending for many years, and demand from the third world will remain flat. We don’t think this will happen, but deflation bulls have a lot of ammunition to make the case. How can you play this trend? Be long treasuries (NYSEARCA:TLT) and keep a good amount of cash. Not great.

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