Goodbye Mr. Stagflation, Hello Mr. Recession

Well, it wasn’t nice knowing you Mr. Stagflation. With inflation on the way out, Mr. Recession will be replacing you. He’ll still be rather unappealing but at least the central banks will have room to ease interest rates — then we’ll eventually get the ever popular Mr. Rebound.

Sure, the U.S. CPI hit an annual growth rate of 5.7% in July. But the main cause of the inflation surge, soaring oil prices, is beating a hasty retreat — as are prices for commodities and foodstuffs (other important contributors). Even rising import prices are going into remission thanks to the recent rise in the U.S. dollar.

Look at how financial markets yawned when the CPI figures came out. Futures on federal fund rates barely moved. Yields on inflation-protected Treasuries (TIPs) fell (the spread of the 10-year TIPs yield over regular 10-year Treasuries yield — a proxy for inflationary expectations — has now collapsed from 2.57% to 2.22% in a little over a month).

Retail sales volumes have been dropping despite the tax rebates issued by the U.S. government. Job losses, falling house prices, and credit rationing are taking their toll. With most rebate cheques already disbursed, retailers are likely to pick up the pace of price discounting in the months ahead, says BMO Financial.

The forces of recession do indeed appear to be in the ascendancy. Japan’s economy contracted at an annual rate of 2.4% in the second quarter, its worst performance in seven years. The eurozone economy shrank in the second quarter, the first contraction since the launch of the euro in 1999. The Reuters-Jefferies CRB index has fallen almost 20 per cent since the peak in July.

The Fed’s latest survey of lending officers shows continuing tightening of credit standards. In the three months ended June 30, total bank credit contracted at an annual rate of 3.7% — the biggest drop in 60 years.

A slowdown in loans coincides with a slowdown in bank deposits — which in turn slows growth in the M2 definition of money supply. M2 had annualized growth of only 2.5% in the three months ended July, compared to 13.2% in the three months ended March, 2008. If inflation is “always and everywhere a monetary phenomenon,” as the great economist Milton Friedman said, then a deceleration in the money supply implies a deceleration in inflation.

In fact, the M2 slowdown implies a drop in economic growth when inflation is taken into consideration. The real money supply (adjusted by consumer price inflation) has contracted at an annual rate of 7.3% in the three months to July 30, “the sharpest three-month contraction since early 1980,” according to Northern Trust.

Comments

[bbzz24:]

The Fed's efforts so far have been targeted at preventing deflation. The additional money that they pumped (replacing bad morgage securties with treasuries) will have impact on future inflation for sure, but we know all too well how they play these numbers.

2008 Aug 19 06:27 AM

[adan:]

it's difficult to see deflation when inflation's been crammed down our wallets for decades, but i think it's part of the boom bust cycle that apparently large money has learned to ride and push to extremes

2008 Aug 19 08:43 AM

[CLH:]

Im surprised that it took people so long to understand. We are in a debt elimination which means people will learn to save. Crazy spending will go down. Right now the best way to make money is shorting gold and commodities and saving dollars which now have value.

2008 Aug 19 08:51 AM

[whidbey:]

CLH where did you get your ideas? Debt elimination? Hell we don't even understand the term yet. There is debt, quasi debt and CDS, not to mention credit cards, auto loans, and commercial. I do credit analysis and you may take for fact that the tumble has just started and will be a terror show when it is more fully revealed. I would not short gold just yet the government is about to some bails that will mean running the bonds out of the Treasury and selling them, it is called monetization. Hold on shorty she is going to buck. Z

2008 Aug 19 11:02 AM

[mark mchugh:]

In case you haven't heard - There's a new 'flation' in town, MANIPUflation. He seems pretty cool, just watch out for his crazy cousin, Hyperin.

2008 Aug 19 07:09 PM