The Ups and Downs of Deflation

by: Babak

Just a few months ago we may have still been engaged in the economic debate of whether inflationary or deflationary forces would win out. On the one hand you had the credit collapse on a global scale which sucked the wind out of the economy and on the other hand you had the immediate and collective response of the Western world to inject mind-boggling amounts of money through monetary and fiscal stimuli.

But today the debate is over. In spite of the inflationary forces unleashed to fight it, deflation has cleary won. We are seeing this anecdotally on the ground as well as trickles of econometric data coming in from North America, Europe and even China.

The US economy is akin to a patient barely clinging to life in a critical care unit (insert US health care joke here). If the Federal Reserve is imprudent enough to raise interest rates from basically zero, it is not difficult to guess what might happen. Needless to say, they are not that stupid.

Even so, the Fed is pushing against a string at this point. They are basically observers like the rest of us, helplessly watching the largest decline in consumer prices in 50 years:

CPI long term chart deflation

The chart below shows the real interest rate (interest rate minus inflation), rather than the nominal rate, its much more famous cousin:

US real interest rate bond yield minus CPI long term chart

If you’re a worrier by nature, this chart should have you biting your fingernails to the nub. Right now, after the globally orchestrated monetary easing, the long term real interest rates in the US are approaching 6.5%. In other words, if we didn’t have deflation at all, it would be akin to having the Fed jack up the reserve rate a couple hundred basis points overnight.

In a deflationary period frugality is rewarded as savers gain without doing anything. The problem is that the losers are those who borrow money because they will have to pay more to retire the debt. In the past, the US miracle economy was fueled by inflation and credit as the US consumer bought more than they could afford with money they didn’t have, and repaid (some of) it with money that was worth less than that which was borrowed initially.

Now we are in a completely different world with a different set of incentives. So obviously we can’t expect the orgy of borrow and spend to start all over again. This may not be all that terrible when you consider that historically many economies have had bouts of deflation without any real detriment to their long term health. In fact, if a spell of deflation helps to bring into balance the twin forces of saving and consumption, it would be a very good thing indeed. Here is a research paper from the Minneapolis Fed on the lack of empirical evidence linking economic depressions and deflation (pdf).

Just don’t expect the US consumer to reprise their gluttony. You can’t dig yourself out of a hole and it looks like the US consumer has finally put down the shovel and started climbing.

Here are some more thoughts on inflation vs. deflation:

Also, here is a free 60 page eBook from Elliott Wave about the dangers of deflation and how to position yourself both defensively and offensively to benefit.

The elite financial community labeled Prechter – the 1980s “Guru of the Decade” – an outcast, a man preoccupied with the concerns of “small children.” Experts from all schools of the economics profession said Prechter’s deflationary scenario was “utter nonsense,” and as likely to happen as “being eaten by piranhas.”

Yet … here it is. Since the real estate top in 2005, deflation has festered its way into almost all asset classes, ravaging the portfolios of millions. If you’ve been spared from deflation’s mighty jaws, you surely know someone who hasn’t.