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0 Feb 25 2010 @ 7:40am by Matt Smith in Capital Markets, Economy, Global Energy, Random, risk management

Negative inflation starts with a ‘d’ and ends in tears

a deflationary environment would make it cheaper to phone home.

I made the above comment in my daily market update last Friday, before realizing the gravity of the adverse CPI (= consumer price index, aka inflation) number released that morning. The core CPI index (which differs from the ‘headline’ number, as it removes two of its most volatile components – food and energy prices) showed a negative print. ‘Big deal, burrito boy’, I hear you cry. But wait, my friend; this was a doozie of a print because it was the first negative print since 1982. Yep, we’re talking the year of E.T., the album Thriller, and the birth of Ben Roethlisberger. Let’s take a quiet moment reflect on how really, really long it has been since then.

Ok, lets move on.

Last week actually saw a double doozie of data releases – the first being the aformentioned 28-year breaking of a duck, while the second designated doozie was from the Federal Reserve (= the Fed), who raised the discount rate from 0.5% to 0.75% late Thursday evening. The discount rate is the interest rate charged to banks for direct loans, so although it doesn’t necessarily directly impact us mere mortals, it does issue a battle cry from the Fed that they are ready to fight the enemy – whatever form they may take.

But herein lies the problem: armed with the weapons to fight inflation doesn’t mean you can do the absolute opposite to avoid deflation. War against inflation lends itself to raising interest rates or decreasing the money supply as two of the more common weapons wielded (incidentally, the latter is where Ben Bernanke got his ‘helicopter Ben’ moniker from; back in 2002 he said the best way to invoke inflation was to throw money from a helicopter). On the flip side, the onset of deflation can be staved off through the promotion of confidence in an economy, but like a bite from a vampire, once deflation sets in, all you can do is let it run its course (ie – become undead).

Japan proffers a deflationary horror story twicefold; not only because it suffered a ‘lost decade’ starting in the early 1990’s, but because the US is on a similar trajectory (a real estate bubble + equity market bubble = zero interest rates and quantitative easing….sound scarily familiar??). That’s not to say the Fed are not aware of the perils of their decisions – quite the opposite. And that’s why we should worry – if we can see them using their silver bullets, we know all too well how many they have left.

deflation = more zombies, less thrills

Now, to wrap this up in our all-encompassing tortilla. Deflation, by its very definition, is a general decline in prices. I am not declaring that we have lost the battle to deflation, I am merely highlighting that deflation is a real and potential risk to our economy. And if this were to happen, energy commodity prices would be dragged lower with every other asset class. Even worse, if the engine-room of the current global recovery – emerging markets – were to avoid such a deflationary environment, it would only exacerbate the problem in the US by continuing to boost global commodity prices. A horrifying prospect indeed. On that bombshell, I’ll leave you with this; the conundrum of how to deal with deflation reminds me of Woody Allen…he once said ‘I got this powdered water – now I don’t know what to add’. The answer for this is the same as it is for deflation…….silence.

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