Sunday, 16 December 2007

Inflation Or Deflation?

So US PPI and CPI was through the roof last week stoking inflation fears and sending investors running for cover as they mulled the possibility that the Federal Reserve may be done cutting rates for the time being. However should we really be worried about inflation?

No doubt there are inflationary pressures and have been for some time, the Federal Reserve has belatedly recognized that, by paying more attention to the headline number in addition to the core. However, was last month's inflation reading really a surprise to anyone considering oil reached $99 a barrel?

But it's not just oil, we know that certain agricultural commodities have been shooting up over the past 12 months. Anecdotal evidence has shown up in some company outlooks such as Starbucks comments on rising milk prices. OK so we know there is inflation out there.

However lets put that aside and turn to deflationary pressures in the US economy. Firstly what is deflation? Typically it is a decrease in the money supply or amount of credit in the system and a decrease in the demand for goods related to the inability to access credit. Sounds like the opposite of inflation doesn't it? Funny that. What evidence do we have to support a deflationary environment? We have:

  • Tighter access to credit both for individuals and corporations , and unwillingness to lend as evidenced by widening credit spreads.
  • $400 billion of Asset Backed Commercial Paper wiped out of existence in 4 months.
  • Falling housing prices across the country.
  • markets for LBO's, asset backed securities and bond issuance have all but dried up.
  • Banks and other financial institutions' balance sheets continue to shrink as they mark down asset prices.

However asset prices as measured by the US stock market are not far from all time highs. The S&P500 is up 3.5% year to date however the US dollar is down -11.8% against the Euro. In Euro terms the S&P500 is down more than -8.0% for the year. Asset deflation is pervasive and is set to continue in home prices, corporate balance sheets and ultimately stock prices.

What of the US dollar? In a deflationary environment you would expect it to appreciate and that's what you've seen over recent weeks. The Dollar has firmed up against the Euro from about 149 to 145. That's not to say it won't go back down again. No doubt it's in for a volatile ride but if the supply of dollars decreases the currency will eventually go in the opposite direction.

Now the Fed is supposedly busy pumping money into the economy however as stated repeatedly the vast majority is of short term duration via repos. There is not a lot of new money out there. Also the velocity of money (the rate at which it is turned over) has decreased sharply which means people are hoarding cash.

Asset prices got out of control due to the easy money environment fostered by the Fed in the early part of this decade. Now it's time to deflate and there is little the Fed can do about it.

On the inflationary side, if global economic growth slows next year then I would expect energy prices to recede, that still leaves food inflation. I'm not smart enough to know how that will play out next year but from where I sit deflationary pressures appear to outweigh inflationary pressures. Anyone else care to take a stab at the inflation/deflation debate? Any comments are welcome.