The Silly Notion of Deflation

Deflation… Bah humbug!  The arguments are still relatively new over whether the global economy is headed for a double-dip recession or just an extended period of slow growth.  There is a separate argument about whether the markets are going to have to deal with a new period of deflation after reports this week.   Comments on deflation (and inflation) from Fed Presidents Fisher and Bullard from yesterday gave reporters some ammunition to make a louder case for deflation.  It is just noise.

Bullard noted yesterday that keeping an “extended period” stance on almost zero-rates could raise the risks of a Japan-like economy.  Fisher noted that the Fed will neither tolerate inflation nor deflation.  Fisher also noted that fiscal and regulatory uncertainty act as a major roadblock to economic growth.

Drawing the comparison of a Japan-like economy will not exactly bring about the greatest cheer.  This morning’s GDP figure is not going to do much for the inflation camp, but it is not the case of big deflation either.  Maybe we are just in a period of ‘stable prices’ rather than a period of wildly higher or wildly lower prices.  Every economist and every pundit is still of course just speculating.  That includes yours truly.  After all, how can you fully predict what has not yet happened?

David Zervos of Jefferies recently issued a 60-year analysis of deflation.  While the 1970’s period was left out for its inflationary period, Jefferies shows the CPI data in its purest form without using any of the “ex” numbers that confuse the data on real world prices.

50s – 2.25 (2.24)… 3.3% average 10-Year Yield
60s – 2.53 (1.79)… 4.7% average 10-Year Yield
80s – 5.22 (3.47)… 10.6% average 10-Year Yield
90s – 2.93 (1.24)… 6.5% average 10-Year Yield
00s – 2.54 (1.14)… 4.4% average 10-Year Yield

Zervos noted, “It looks like current 10 year yields at 2.90% cannot even find value in a 1950s world with inflation some 30bps lower than the past decade…. there are very few signs of deflation and 10 year yield are pricing in excessive (and unfounded) risks of deflation. Something has to give and I’m guessing its 10 year yields.”

Barry Ritholtz of “The Big Picture” blog wrote yesterday that deflation is a fact and that a rise in Treasury yields will be the warning sign of inflation down the road.  Forbes took the opposite stance and said that deflation fears are overblown.

Deflation is a period of contracting prices.  In short, it is the theoretical race to zero in prices.  It also leads to cash hording when you know that the same goods will cost less a day later.

You could use the gold argument in this scenario, but gold has acted with a mind of its own.  During the period that gold rose above $1,000 and then ultimately to north of $1,200 per ounce, oil has remained range-bound in a price band of roughly $70 to $80 per barrel.  Gold is also not widely used in the economy.  Some can argue that gold is even irrelevant.  What would deflation do for housing prices and rents?

For deflation to truly come, we’d be looking at oil price far south of today.  Is that $50 per barrel?  Maybe.  Why not $40 per barrel?  The problem is that it is hard to find anyone who will confirm that oil is heading down toward $50 per barrel.  The economics of oil drilling would likely prevent that because as oil prices get lower new production would be mothballed because of the economic loss.

Bond yields are extremely low. Mortgage rates are at all-time lows.  The economic growth is coming at a slower pace than before.  And on and on.

There is one risk out there that the deflation camp can use as their thesis.  We recently argued about all the safety nets against a double-dip recession.  That stance has not changed.  If there is a true double-dip recession, the deflation will likely come into play.  Another case would be serious population decline, which never seems to occur.

It was just a year ago that economists were predicting a period of hyperinflation ahead.  The reason was simple enough.  The government here (and governments elsewhere) were printing massive amounts of money to fend off a depression rather than just a recession.  Simple enough.  Throw in a trillion or more into the economy, and it would make sense that higher prices would follow.

Steel producers, aluminum producers, gold producers, oil producers and their counter-parts can all prevent deflation.  If prices get too low, they just slow down the production.  That cuts supply, which acts as a price buffer in the supply and demand models.

Japan is Japan.  Their latest growth showed that in fact their was no growth.  That country has never cleaned house after its last bubble about 20 years ago.  Will China, Europe, India, and the United States make the same mistakes?  That remains to be seen.

The U.S. will ultimately run into problems if the interest rates are kept at near-zero indefinitely.  What an “extended period” means varies from source to source.  Our own poll taken over the last month indicates that rate hikes in the U.S. are likely more than a year out.

Our guess, the theory of deflation can be talked about until the end of days and it will just remain theory.  Deflation, at least in the U.S., seems to be more of an economic theory rather than an economic reality.

JON C. OGG