"Unless the Fed continuously 'raises the ante' by increasing the level of stimulus, I believe the Fed's actions likely cannot offset the fundamental deflationary forces in the economy. Additionally, foreign governments have actively raised rates and reserve requirements in efforts to slow down inflationary pressures in their countries. These efforts likely start putting a brake on world economic growth"
- Stock Ideas to Money, April 26 2011
With the Federal Reserve considering becoming more active, foreign central banks increasingly stepping in, and the yield on the ten year and thirty year bonds rising; I return to this thought and ask whether fundamental deflationary forces likely subside. To start, I have summarized an analysis of price volatility in the following table.
| Segment | Direction | Argument |
|---|---|---|
| Commodity | Deflationary | Commodity prices have been falling for the last few months, applying deflationary pressure in the cost structure of the world economy. |
| Wages | Deflationary | Wages have declined 10% since December 2007, due primarily to the significant number of unemployed in the country. |
| Financial Assets | Deflationary | With the S&P 500 down significantly from its highs, financial assets have generally declined over the past few months, reducing the wealth of many in the country. |
| Tangible Assets | Stable | Housing prices remain well off their highs from a few years ago, but appear more stable than in the past. However, banks appear more aggressive in acting against owners who have missed a payment, which could push prices lower if the banks choose to try to expedite the foreclosure process and sell the property. |
| Currency | Mixed | The US Dollar index has strengthened recently due largely to weakness outside the US. That said, the strength of the dollar has begun to weaken again. If the dollar continues to slide, inflationary pressure may return to the U.S. economy. |
| Fiat | Deflationary | Governments remain fairly committed to austerity measures as countries in Europe attempt to reduce debt levels and the right-wing in the US continues to favor a balanced budget. Reduced spending is likely a deflationary force in the economy. |
| Goods & Services | Inflationary | The CPI-U increased almost 4% annually in August, a lagging indicator, in my opinion, of inflationary pressure from higher commodity prices earlier in the year. Weak consumer demand suggests this segment could turn deflationary once cost pressures subside. |
The key points to pull out, in my view, are:
(1) The longer-term fundamental trends of declining wages and government austerity remain deflationary. Until either fiscal policies become more expansionary or market imbalances are allowed to correct themselves, I believe these fundamental deflationary pressures remain two of the more dominant forces in the economy.
(2) The more volatile segments of commodity, financial and currency have recently swung towards deflationary pressures after providing inflationary pressure for a couple years. These are the sectors affected most immediately by monetary policy in the current low interest rate environment, in my view. The turn-around during the past week in many of these markets, with equity and commodity markets up and the dollar down, likely is due in some part to recent articles suggesting another round of QE is coming. The primary reason for improvements in these markets, in my view, was increasing signs of progress towards the European bailout. In short, activist government policies but no real change in the underlying problems.
(3) The one segment that shows obvious signs of inflationary pressure is goods and services. However, an important distinction needs to be made about this indicator. The CPI is relatively high right now because businesses have been trying to pass along rising costs to customers, in my view. I do not believe it is high at the moment due to excessive demand relative to supply. This point is illustrated by the relatively weak shipments ahead of the Christmas season.
The conclusion is that my Sagflation theme remains in play. I believe fundamental deflationary pressures remain in place but if governments around the world keep announcing new fiscal and monetary stimulants I likely need to exit my 30-year treasury position.
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