The case for worrying about deflation, or at least continued disinflation, is fairly compelling, as we noted yesterday. But is deflation fate? No, at least not yet. Much depends on the Federal Reserve’s actions in the weeks ahead. There’s also the question of how the economy fares. Was the recent slowdown in economic momentum temporary–or the sign of something more ominious for the business cycle?
I’m increasingly persuaded that deflation is still a rising risk, even if it’s not destiny at this point. If there was ever a moment to be worried about the D risk, this is it. But there are plenty of strategists who disagree, arguing that inflation and related hazards are the bigger problem. For those who take this view, the implied trade is selling and otherwise avoiding bonds—Treasuries in particular. Of course, that’s been a losing trade this year, which is to say that the case for deflation has generally swayed the crowd. Is that simply evidence of irrational exuberance? Or is the fundamental argument for worrying about deflation based on solid ground?
There are no definitive answers in economics when it comes to the future, and so we’ll simply have to wait for the incoming data to confirm or reject our analysis. Meantime, let’s consider the counter argument to the deflation-is-coming crowd, which includes the Treasury market. What are the inflationistas thinking (or drinking)? For some perspective, here’s a small sampling of recent analysis…
►Inflation, not deflation, Mr. Bernanke
“Inflation, not deflation, will dominate the global economy. The deflation scare causes the central banks in the developed economies to sustain a loose monetary policy. It will fuel inflation in emerging economies. Through trade, currency markets, and ultimately inflationary expectations, inflation will hit developed economies.”
►Bernanke Must Raise Benchmark Rate 2 Points, Rajan Says
Scott Lanman and Simon Kennedy/Bloomberg
“Raghuram Rajan accurately warned central bankers in 2005 of a potential financial crisis if banks lost confidence in each other. Now the International Monetary Fund’s former chief economist says the Federal Reserve should consider raising rates, even as almost 10 percent of the U.S. workforce remains unemployed.”
►The Fed Can Create Money, Not Confidence
George Melloan/Wall Street Journal
“Inflation—or stagflation—remains the more serious danger than deflation.”
►A bull market in pessimism
But actual inflationary expectations may not have declined as much as bond markets imply. Inflation-linked bonds are less liquid than their nominal cousins. When investors rush to government debt, they pile into nominal bonds: that is what happened after the Federal Reserve marked down its economic outlook on August 10th and said it would reinvest maturing mortgage bonds in its portfolio into Treasuries. That extra demand squeezes the spread over inflation-linked bonds, bringing down the implied inflation rate…
America’s 12-month core-inflation rate, which excludes food and energy, has fallen from 2.7% in early 2007 to 0.9% in July, but it may be bottoming out. Most of that drop has been because of falling rents, and they now appear to be headed higher again as apartment vacancies start to drop. Core producer prices also rose faster than expected in July. The deep freeze in private borrowing has begun to thaw, too. On August 16th the Fed reported that banks had eased lending standards for small businesses; sales of junk bonds are rocketing.
►Why Quantitative Easing is Likely to Trigger a Collapse of the U.S. Dollar
John Hussman/Hussman Funds
“As one might infer from the content of this week’s remarks, my view is that the quick initiation of quantitative easing by the Federal Reserve has significantly changed the prospects for foreign currencies and by extension, precious metals. For the past couple of months, I’ve observed that deflation risks in response to fresh economic weakness were likely to provoke weakness in the commodity area, even if long-term inflationary concerns were accurate. However, my impression is that the Fed’s immediate initiation of quantitative easing may cause investors to take deflation concerns ‘off the table.’ This is important, because even as we observe economic deterioration, the potential for a “deflationary scare” is likely to be more muted than we might have expected without explicit quantitative easing actions.”
►The Nemesis of Long-Term Yields Bottom
Shalom Hamou/Seeking Alpha
“I think that long term rates should soon be bottoming as the undervaluation of long term yield become unsustainable from an option valuation point of view…”