Off the Mark

The meltdown in the financial sector and the massive deleveraging taking place in various markets has pushed concerns about rising inflation to the back burner.

For Fed officials who have long been fighting "the last war," that is not such a good thing. In spite of the fact that contractionary winds have increasingly wended their way through Wall Street and Main Street, these policymakers persist in believing that a return to the inflationary conditions that prevailed in the late 1970s is the biggest economic threat we face.

In reality, recent events seem to make it clear that such fears are off the mark, at least in the short run. In "Goodbye Lehman, Hello Deflation," Reuters columnist James Saft offers up his thoughts as to why this is so.

A few short weeks, a few banking failures, a massive fall in oil and commodity prices and deflation is back on the agenda.

The events of the weekend -- the failure of Lehman Brothers, the takeover of Merrill Lynch and insurance giant AIG's reported emergency appeal for Federal Reserve aid -- have given another kick to the vicious cycle of debts going bad and asset prices falling. More markers will be called, more assets marked down, more capital destroyed, less credit offered.

As for recapitalizing the banking system, sovereign wealth funds and anyone else with eyes and ears will be waiting on the sidelines for things to look slightly less grim.

Meanwhile, back in the real economy large swathes of the developed world from Tokyo to Berlin to Los Angeles have been hurt badly by the credit crunch and are very likely already in recession.

Oil and commodities prices are falling rapidly in response. Oil at about $95 a barrel is 35 percent below its summer peaks and the benchmark commodities index .CRB is down by more than 25 percent since July.

So even with inflation still at heady levels, the chances that we slip close enough towards deflation that it becomes a concern have increased markedly in recent days and weeks.

"Deflation looms, it certainly does loom," said George Magnus, senior economic advisor at UBS and a man who has predicted both the credit bust and many of its implications.

"The cycle in which debt destruction and asset price destruction reinforce each other clearly has a very, very strong negative effect on the economy. This effect is both direct and on banks, who are supposed to try and create the credit that makes economic growth possible."

Government bonds are certainly not showing a lot of worry about inflation, though this in part reflects a flight to safety as investors seek to hold the most secure instruments. Treasury futures had their biggest gain in 20 years on Monday and two-year yields dropped 40 basis points. A look at inflation protected bonds shows that market pricing in the least amount of inflation since 2003, when the Federal Reserve was last actively fretting about deflation.

A real estate bust and systemic banking crisis in Japan helped usher in a period of recession and deflation -- falling prices -- starting in the early 1990s. As production and consumption are delayed to take advantage of future lower prices, deflation can feed upon itself and be difficult to stop.

Japan resorted to extraordinary measures to halt the price drop, slashing interest rates to near zero and force feeding liquidity into the banking system. Inflation finally revived only with the help of the global commodity price boom.

WHAT INFLATION THREAT?

It certainly looks as if the threat of inflation being exported from emerging markets has now diminished. China's central bank cut interest rates on Monday by 27 basis points and eased reserve requirements it places on banks, moves taken out of concern for deteriorating growth. Inflation in China has eased markedly in recent months; consumer prices actually contracted slightly during August.

To be clear, inflation in the United States still has a way to fall; consumer price inflation was 4.5 percent in July, the highest since 1991, and food prices may stay stubbornly high for some time to come.

So why will the demise of Lehman make price contraction more likely?

An enormous amount of leverage is being taken out of the system suddenly, prompting new sales of assets into a market already suffering indigestion. This will drive prices for many assets lower, which will in turn force other firms holding those assets on their own balance sheets to mark the value down. This creates even more need for new capital, and makes further failures of banks and insurers more likely.

Companies will find it tougher to get loans and will be more prone to throw people out of work.

The authorities have powerful weapons with which to fight deflation. They are already using one, having effectively nationalized the U.S. mortgage sector.

And there are also interest rate cuts. At this writing, the market was actually betting the Federal Reserve would cut rates when it decides on Tuesday.

Then there is the currency printing press. We are of course nowhere near that, and in some ways if inflation ebbs away the Federal Reserve will have a less complicated job than if they were trying to aid the recapitalization of a banking system with one hand and fight inflation with another.

Russell Jones, global head of fixed income research at Royal Bank of Canada in London, points out that CPI in the United States tends to fall by half or two-thirds following a recession and that its successive troughs have been lower and lower.

"At the very least the inflationary risk has diminished very sharply, at the most we could be moving to a problem of the opposite kind," he said.

Comments

[roger]

Everybody now is focusing on the financial problems in the financial sector,but good times
mean that manufacturing retail & consuming are humming in unison,
not so in the present condition.
retail is on a - tide,manufacturing is taken a leave of absence,
consumers are experiencing a serious liquidity drought,yes deflation
is at the next stop sign

[Jes]

Both RealClear and Huffington Post are going on and on about the mindless he said/she said of the election. On the pop station I heard the djs talking about whether an actress had sex with a stripper. On NPR someone is unhappy that Catholic schools are becoming public charter schools.
And in the last four days, the US financial system (well, the world financial system) has suffered unimaginable shocks and seems to be in danger of toppling entirely.
My guess is that even the falling prices of deflation won't be seen as anything worrisome by the citizenry, probably rather as some nice magic that the winning candidate can claim to have done.

[Leon Fainstadt]

The thieves are running wild with taxpayers money. Somewhere in a swiss resort our bankers, politicians, and crooks, warm their hands in front of a fireplace with roaring logs. Drinking cognac and looking for an escape the good old boys, who went to the finest schools, have turned the American dollar into monopoly money. Was that your front door being kicked in by the bankers,realtors,brokers, and all the rest who gladly handed you the loan papers while they lined their pockets. Well guess what? They are lining them all over again and Bernanke and Paulson must have figured a way to come out ahead for themselves. Someone tell me. Where's the beef? Or is it tainted too.
Is that a burglar alarm I hear? Wait its the "cops" robbing us twice. The new sign outside reads: Home in Forclosure. Call the bank for details.

[Jesse]

More Power!

http://tinyurl.com/4lwz42

[Ellen Jackson]

I must say, Michael, you've shown admirable restraint. Not even a tiny, little "I told you so..."?