"Deflation?!" (Saut)

This article is a guest contribution by Jeffrey Saut, Chief Investment Strategist, Raymond James.

“With Treasury bond yields at, or near historically low levels on one hand, but with commodity prices near 8 month highs; and, with the personal feeling that outside of a home, a computer and a flat screen TV, the cost of living seems to only go higher on the other hand, here is another perspective on the inflation/deflation debate. Since June 1981, when Volker started to lower interest rates from 20% as high inflation rates started to fall, the absolute level of CPI rose 142% to the high in July '08 (90.5 to 217). Deflation is defined as a decrease in the general price level of goods and services; but, to quantify the current fall in prices, the CPI has fallen just 1% from its all time high. This tiny price move, notwithstanding we are still near an all time high in the daily cost of living, has led to talk that the Fed needs to do more to avoid deflation at all costs and thus create inflation via more QE (quantitative easing ). An example, oil goes from $50 to $85 in one year and the next year falls 1% to $84.15 and we’re told there is deflation and deflation is bad.

“The view is that with excess capacity and a lack of demand combining for softer prices, we must have even lower interest rates to spur more borrowing and thus more economic activity to increase demand and thus reduce the large output gap. Think about this, policy makers think we should raise the cost of goods and services in order to cure a lack of demand. The law of supply and demand says lower demand must be met by lower prices in order to get to the proper equilibrium. What the Fed really wants to do is create inflation in order to not deal with an overleveraged economy in the most responsible way, either paying debt off or writing it down. They want us to pay off the debts with inflation. Inflation is a hidden tax on every single one of us and thus the corollary to deflation is a tax cut. Inflation is good for those who are highly indebted as those debts get paid back with inflated money while deflation or flat prices are good for those who save and have little debt and vice versa. ”

“In the state of deleveraging the US is in, where the low cost of money doesn’t matter much to an individual or a business in making spending and investment decisions, artificially low rates mostly spur just refinancing and higher commodity prices. While maybe, or maybe not, higher commodity prices make their way into government consumer price statistics, the commodity inflation is still there and has to be eaten by someone. Food for thought.”

...Peter Boockvar of Miller Tabak

I read Peter Boockvar’s prose after reading a debate between two top economists. One is in the deflation camp and the other is not (http://www.nytimes.com/2010/08/06/business/economy/06deflation.html?_r=1&src=busln). To be sure, I was quite impressed with Peter’s cogent comments against deflation. Indeed, deflation has always been a “bad bet,” except for the 1930s. Currently, however, deflationary concerns are swirling on the “street of dreams;” and, I don’t believe them. I think the present-day policies will actually prove inflationary. While it’s true transfer payments to middle/lower-income recipients are not going to be all that simulative (or inflationary) given falling housing prices, that still does not spell deflation. In such an environment recipients will probably not spend the transfer payments, but rather save them to offset the negative wealth effect of lower housing prices. A better strategy would be making “transfer payments” to a program like the WPA of the 1930s. Recall, the Work Progress Administration was crafted in 1935 to employ the unemployed with the objective of putting people back to work by building infrastructure projects. Such operations have a far greater “multiplier effect” (for every $1 spent you get a $2+ impact) in the economy. Accordingly, given the current economic policies, the nascent economic recovery is likely to be slow, but with no double dip. And, that what’s happening as the recent economic reports have softened, punctuated by last Friday’s ugly employment numbers. Nevertheless, the economy will recover with inflation (not deflation) likely to follow.