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Deflation? Try a Tale of Two Inflations

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By Dian L. Chu, Economic Forecasts & Opinions

The crisis in Europe is causing concerns about deflation in the U.S. and other developed economies after weeks of financial-market turmoil. The fears are most pronounced in Europe, where a combination of spending cuts and tax increases could weigh on economic growth and feed into deflation.

Financial markets are reflecting a diverging expectation. Gold prices have been soaring—a potential indicator of inflation fears—while many other inflation indicators are going the other way.

In the United States, the loose monetary policy has not resulted in any significant rise at the consumer level or changes in inflation expectations, as evidenced by the sharply slowing Consumer Price Index and plunging M3 money supply.

Biflation... Not Deflation

Despite the seemingly tame headline inflation numbers, consumers never seem to see price declines in certain categories like education and health.  For instance, prescription drug inflation escalated to 5% from less than 3% in 2007 and 2008.

So, it is pretty obvious what we have here--biflation--instead of deflation. Biflation is a state of the economy where inflation and deflation occur simultaneously.  (Chart 1)

The price increase of commodities is caused by the increased money flow (via loose monetary policy) chasing them. On the other hand, the growth of economy is tempered with high unemployment and decreasing purchasing power. This has resulted in a greater amount of money directed toward essential items (inflation) and away from non-essential items and things required credit to buy such as house and cars (deflation).

Inflation In the Supply Chain

Furthermore, the price at the producer level paints an entirely different picture. Producer Price Index (PPI) for finished goods was up 5.5% year-over-year. Further up the supply chain, signs of inflation are even more worrisome.

The PPI for intermediate goods increased 8.6% year-over-year in April, while core PPI for crude materials, excluding food and energy, shot up 60% year-over-year in April (Chart 2).

Meanwhile, the Purchasing Manager Index (PMI) report shows manufacturing sector expanded in May for the 10th consecutive month, and the overall economy grew for the 13th consecutive month. Backlogs are also increasing which further points to the inflationary pressure in the pipeline. (Chart 3)

A Tale of Two Inflations

While all of that money Federal Reserve pumped into the system could in theory cause inflation, the Fed is counting on weak banks and slack in the economy would weigh against that. Indeed, it is likely that crude material price increases could begin to move down the supply chain; however, end markets are still too weak to allow a full price increase.

So, in the near term, biflation could be around through possibly 2012 with pockets of inflation seen in certain sectors such as energy and feedstock chemicals, and deflation/low inflation in other sectors, netted to a moderate headline inflaion number.

Eventually, as world economy picks up speed, a tale of two inflations would emerge with the very different pace between the developing and advanced economies (Chart 4). 

Stagflation--high inflation with slow growth--could manifest in the developed countries like the U.S. and Europe, while the emerging nations such as Chindia would face the challenge of hyperinflation.

Spooked by Europe

At the moment, deflation is still something that cannot be completely ruled out with the private sector deleverages at a faster pace than the Central Banks can fund.

However, I believe the more likely scenario is that the fall of the euro could save Europe from deflation, and the Fed's aggressive money pump, including a possible second stimulation package, will likely keep the U.S. out of it as well.

Sudden Hyperinflation?

Nevertheless, the somewhat overhyped debt crisis in Europe seems to have spooked the market as well as the Fed to grossly miscalculate the risk of inflation vs. deflation. As such, more stimulus and inappropriate timing of monetary and fiscal policies could lead to a sudden hyperinflation.

Invest for Inflation

In that sense, it is advisable to allocate for inflation protection so not to put all the eggs in one direction, in case some investors have positioned largely in anticipation of a deflation.

- Gold and other precious metals via physical holding or ETFs – about 3-5% of portfolio as a severe inflation defense
- TIPS Bond - an indexed portfolio of inflation-protected bonds such as the iShares Barclays TIPS Bond Fund (TIP) is a good place for cash to protect against inflation.
- Hard Assets & Resource Producers – Agriculture sector still seems reasonable enough compared with other “hot” commodities. Indexed ETFs such as MarketVectors Agribusiness ETF (MOO) is one option.
(Also see Crude Oil and Copper: Better Value Than Gold and Commodities: Time to Go Long and Physical.)

Economic Forecasts & Opinions

 


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Tue, 06/15/2010 - 08:49 | Link to Comment dan22
dan22's picture

New Economic Term Developed, A Yo-Yo depression-

 Throughout first 15 years of the 21st century investors and economists where debating heavily upon the economic environment. Is it deflation, inflation, stagflation or hyperinflation? Eventually, a new term emerged- Yo-Yo depression which describes an economic environment in which the economy moves violently every year or so from inflation to deflation. Source: The inflation/deflation debate: The complete list of arguments for hyperinflation and deflation
Mon, 06/14/2010 - 12:34 | Link to Comment defender
defender's picture

Dr. Berninger has some interesting things to say about the whole inflation vs deflation debate on youtube.  He sees them as separate activities that then give us the headline numbers that we see.  Check out his earlier videos on his youtube channel here:

http://www.youtube.com/user/jberni1?feature=chclk

Note: he also has a german channel, for those that can spreken it.

Mon, 06/14/2010 - 08:07 | Link to Comment Species8472
Species8472's picture

Invest for inflation with TIPS. Ibonds used to be a good alternative, you don't have to pay taxes on gains in the par like you do with Tips. Several years ago the treasury limited the annual amount of Ibonds an individual could purchase to $5000, (and also 5000 in paper from a bank). Thats not much, anyone know why?

Mon, 06/14/2010 - 09:38 | Link to Comment pitz
pitz's picture

TIPS don't really help you out here very much.  Why?  Because the government, to understate inflation (and to keep its borrowing costs low), will, undoubtedely, adjust the composition of the CPI index, to include ever greater amounts of items that are deflating, simply to offset the very inflationary items that are present.

 

Mon, 06/14/2010 - 07:59 | Link to Comment anarchitect
anarchitect's picture

Education and healthcare keep going up in price because they're heavily regulated by government, and in large part run by government as well.

The main reason gold is going up is wealth preservation.  It protects not just against inflation, but also against defaults during deflation.

Good to see your observation that hyperinflation can happen suddenly.  However, the West is not immune.

3%-5% in bullion?! You can not be serious! Right now it should be at least 20%. Personally, I have one third in cash, one third in bullion, and one third in other things, primarily precious metal mining stocks.

TIPS are pointless when the CPI statistics are a lie. Besides, I think the US debt should just be defaulted on. This will make it impossible for politicians to borrow significant amounts again, and it will teach everyone who lent the government money, thereby supporting their immoral activities, a lesson that they won't soon forget.

Mon, 06/14/2010 - 17:04 | Link to Comment ajar
ajar's picture

3%-5% in bullion?! You can not be serious! Right now it should be at least 20%. Personally, I have one third in cash, one third in bullion, and one third in other things, primarily precious metal mining stocks.

TIPS are pointless when the CPI statistics are a lie. Besides, I think the US debt should just be defaulted on. This will make it impossible for politicians to borrow significant amounts again, and it will teach everyone who lent the government money, thereby supporting their immoral activities, a lesson that they won't soon forget.

TIPS are subject to government meddling . . . but so is gold: possibility of a high profits tax (it's now 28%), or outlawing personal ownership (in the national interest, of course) to remove competition with fiat. Maybe it would be good to have some of both?

Mon, 06/14/2010 - 09:18 | Link to Comment umop episdn
umop episdn's picture

Wisdom spoken here.

Mon, 06/14/2010 - 07:32 | Link to Comment New_Meat
New_Meat's picture

Despite the seemingly tame headline inflation numbers, consumers never seem to see price declines in certain categories like education and health.

Inflation in education?  Let's see, Congress is looking to support "affordable" higher education.  Is that anything like "affordable" housing?

- Ned

Mon, 06/14/2010 - 10:07 | Link to Comment LauraB
LauraB's picture

Exactly!  Education, healthcare, housing ... everything the government decides to "help" people afford ends up costing a fortune! The only ones they end up helping are the banks.  If they'd just let the markets work, all of these things would be more affordable.

Mon, 06/14/2010 - 06:48 | Link to Comment MarketFox
MarketFox's picture

Another possibility is that both deflation and inflation are inadequate descriptions.

Here is one reason....

A hardworking US citizen saved money and did not incur debt.

The total savings was $1,000,000.

The savings in 1999 earned 6% = $60,000

The savings in 2010 earn $3000

Since the retired worker lives off the interest of their work, the income has dropped but prices remained the same, thus the inflation rate has become 57000/3000 which was imposed by the Fed Reserve and US Government policies.

This is not 100% inflation, this is 1900% inflation defined as the rewards to work.

......................................

Thus it is rewards to work, and not inflation nor deflation that is a more proper measure of a healthy economy.

This is the one big concept that Bernanke and his ilk have totally missed.

They do not teach this in current day economics, not even at Princeton, Harvard, or Yale.

 

Mon, 06/14/2010 - 13:30 | Link to Comment RockyRacoon
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Do you ever come back to see if there are any comments to your posts?  Even my dog will go sniff his own turds periodically.

Mon, 06/14/2010 - 19:25 | Link to Comment marc_hanes
marc_hanes's picture

I am curious as to why ZH has not banned these posts. I welcome a comment from TPTB.

Mon, 06/14/2010 - 02:23 | Link to Comment Popo
Popo's picture

How is this different from stagflation?  Price increases coupled with contraction of the money supply = "stagflation", no?

 

(I can't help noticing that the Wikipedia entry on "biflation" was written by the analyst who coined the term... and not by an economist... er... this smells like someone's attempt to coin a term)

 

 

Mon, 06/14/2010 - 02:31 | Link to Comment pitz
pitz's picture

Its only 'stagflation' if you're invested in assets that are deflating, expecting to receive a return from them (ie: bonds, a career in real estate or banking, etc.) while everything else (ie: consumer staples, oil, engineered goods) is inflating.  The concept of 'stagflation', otherwise, is simply nonsensical.

 

 

Mon, 06/14/2010 - 01:17 | Link to Comment Escapeclaws
Escapeclaws's picture

Is it necessarily the case that gold has been rising due to expected inflation? I got the impression that it's been rising because of declining currencies. Because of the fall of the euro, Europeans have been hedging against that by buying gold, for instance. Before that, it was the decline of the dollar that was partly responsible for pushing dollar holders into gold. At that time, the euro was very strong, so there was less pressure on Europeans to buy gold. Furthermore, there is heightened political risk, particularly in the middle east, these days. So gold purchases could represent a hedge against that. Finally, nations such as China and India have been buying gold. This could back up their own currency in a world wide economic collapse. Countries that have more government-owned gold could partially back their currency by gold, thus protecting the value of their currency relative to pure fiat currencies like the dollar.

Mon, 06/14/2010 - 02:36 | Link to Comment pitz
pitz's picture

Gold could be rising because there is a very strong expectation that the bond market is in danger of collapse, or at the very least, a significant loss of value.

The 1970s experience was that gold peaked out pretty much at the bottom of the bond market (and the height of interest rates).  In other words, it was perfectly negatively correlated.  This is what makes gold so interesting, and by extension, makes the Canadian stock market so interesting relative to that of the US stock market (the TSE index was, at one time, double that of the Dow 30 in numerical terms, so if we get Dow = 36,000, then we will at least see TSE/TSX = 72,000!).

Mon, 06/14/2010 - 10:40 | Link to Comment Escapeclaws
Escapeclaws's picture

So gold was positively correlated with interest rates, which were raised to quell inflation, as I recall. Thus if gold is negatively correlated with bonds, it is positively correlated with inflation, which is what the author of this article seems to be saying. However, this time around, gold has been rising without inflation and I believe that has mainly to do with currencies depreciating against each other. Europeans preferred to buy gold to buying US dollars as the euro dropped.

Mon, 06/14/2010 - 10:59 | Link to Comment pitz
pitz's picture

They're buying gold with the expectation of strong inflation in the value of engineered/produced goods, and strong deflation in the value of bonds and other paper/highly leveraged assets such as real estate. 

Sun, 06/13/2010 - 23:46 | Link to Comment dryam
dryam's picture

Eventually, as world economy picks up speed, a tale of two inflations would emerge with the very different pace between the developing and advanced economies (Chart 4). 

 

I don't think it's exactly a given that the world economy will pick up for another 10+ years.

Mon, 06/14/2010 - 00:50 | Link to Comment dcb
dcb's picture

It is a myth that economic activity is required for inflation. think germany after ww1 and Rhodesia (zimb...). The continued use of this fiction allows the fed to justify low interest rate policies. do you actually believe the crap they talk about?

 

Mon, 06/14/2010 - 01:35 | Link to Comment Spitzer
Spitzer's picture

Thats right.

The 3 nations currently experiencing 25%+ inflation are Venezuela, Afghanistan and Mongolia.

Mon, 06/14/2010 - 01:35 | Link to Comment pitz
pitz's picture

Absolutely!  Hyperinflation is characterized by the lack of real economic activity (ie: having the entire population unemployed, or worse, employed as civil servants, bankers, or speculators). 

Mon, 06/14/2010 - 06:20 | Link to Comment Monkey Craig
Monkey Craig's picture

Great point....plus think of all the lawyers we have! The product they 'produce' is only desired by mega corporations, governments or those trying to sue their employer.

Mon, 06/14/2010 - 09:59 | Link to Comment steve3828
steve3828's picture

No such thing as "biflation". It's just inflation.  The problem is that government measures such as the CPI don't pick it up.  The decrease in purchasing power of a currency IS inflation even if it's uneven across goods.

Sun, 06/13/2010 - 22:41 | Link to Comment russki standart
russki standart's picture

In summary, we are likely to experience price inflation for the things we need, such as food and energy, and deflation for things that are nice to have, but not necessary in the short run, such as consumer electronics, second homes, etc.

Mon, 06/14/2010 - 09:32 | Link to Comment Hdawg
Hdawg's picture

exactly,

1) inflation in taxation

This is obvious and being introduced in UK/Europe right now and US shortly (Cap and Trade, VAT).

2) when deflation in luxury goods hits the wall and prices can't go down any further beacuse they reach production costs

We are getting to this point (food stamps usage in US and riots in Europe as obvious proof)

3) inflation in the stuff we need (food and energy)

We are seeing this right now with the supression of commodity prices (PMs (oil price largely pegged to gold thanks to the saudi's!) and agriculture).  Physical shortages are starting to show up in the system as the which is starting to expose the ponzi price supression.

This is all set to crescendo at the end of this year (once Obama passes the last of his treacherous laws.. Cyber Security, Enemy Belligerent Act, Cap and Trade).

That's when we go from biflation to hyper, hyperinflation and the end of the current fiat system.

 

 

Not Long to go now.

 

 

Sun, 06/13/2010 - 22:53 | Link to Comment pitz
pitz's picture

Exactly.  Bonds will deflate (ie: lose value), and take housing, and anything that is heavily financed, along with it.  Rising out of the ashes will be the prices of consumer staples, high-value engineered goods (ie: electronics, computers), and anything imported.

Over time this will destroy the US financial industry, while restoring purchasing power and profitability to the US engineering and science industries which have been pretty much destroyed over the past 10-30 years.

Mon, 06/14/2010 - 09:49 | Link to Comment Jean Valjean
Jean Valjean's picture

I agree with this completely.

For thirty years, the wall street/federal government complex has been skimming and then stealing the innovation of the private sector (through debt and equity market manipulation and inflation of the currency) but they got too greedy and the dam they built is breaking.

Pretty soon, it might actually pay to be an engineer again.  And wall street might be seen for what it really is - a charlatan.

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