Wednesday, June 11, 2008

Why Not Deflation?

Almost everywhere on the blogosphere and mainstream media, there are posts/articles detailing how inflation is running rampant and that recent Fed policy mistakes may push inflation to that of the 1970's. The more analysis I do, the more I think investors / economists are not fully grasping what a declining economy (with declining home values) can do to price levels. I think this has all the variables required to make a strong contrarian case.

CPI specifically has been a huge target (and justly so), but on a going forward basis, the US is an economy defined by falling home prices and the impact that has spread from these falling home prices.

But what makes up CPI? Lets take a look:

Shelter makes up more than 30% of CPI, with transportation, food, and medical running significantly behind at ~15%, ~12%, and ~5% respectively.


From 1997 - 2007, CPI significantly understated the impact of shelter for the 30%+ of Americans who don't live in a dwelling they own (almost 50% for those who, like me, live in New York). This understatement shifted dramatically last year after home prices dove off of a cliff. Now, with the homeownership rates likely to decrease dramatically over the next few years, the importance of ACTUAL home prices on inflation (not wealth) will play a larger role in pricing as homes become more affordable. Thus, it is my hypothesis that declining home prices will cause CPI to be OVERSTATED going forward.


Medical costs have trended surprisingly low in recent years (note: the three year rolling period likely understates the level, but YoY figures are VERY choppy). Will medical costs continue to rise from this level? While many are critical of an Obama Healthcare plan, with the assumption Obama wins, I view it likely that medical costs will stay inline or decline.

Transportation costs have also been surprisingly steady (not sure I buy into this completely). The big pain, especially in recent years has been rising fuel costs and commodities. Looking at the year over year change in gasoline price below, one can clearly see why this is in everyone's mind.

However, in my opinion we are now at an important fork in the road with oil prices. On the one hand, if the price of gasoline were to increase, it would have to be dramatic to cause further inflationary pressures. Until two months ago a level of $150 a barrel by next June was unthinkable, but with that $150 price the YoY increase would be only ~10% (significantly lower than recent memory). On the other hand, if prices were to decline to mid-2007 levels, YoY change would be in excess of 50% to the downside. With many analysts listing the long term price of oil at $85 (and Japanese officials listing a fundamentals based value of $60) is it possible our short term biases may be wrong in assuming $200 oil is just around the corner?


While high energy /commodity costs will push manufacturers to increase prices, it is my view that a slowing economy will prevent that from happening. I won't go into specific details as there have been plenty in recent weeks / months (i.e. here, here, and here...), but with prices already declining in non-necessities, the possibility of a decline in oil, and the definite decline in home prices (which again makes up 30%+ of CPI), I view it possible that CPI is already overstated. While I don't think there is a risk that the U.S. will match Japan's lost decade, I view deflation as a serious enough threat to secular growth that it should not be completely ignored.


  1. I think you hit the nail on the head, but I think I can clarify why you are hesitant to make the deflation call.

    This is one of the problems with defining rising prices as inflation. Right now, the money supply is declining, or we currently have deflation, yet prices are going up, and everybody is screaming inflation. But if you misdiagnose the problem, you cannot treat it correctly.

    The problem with most analysis is that they see the value of money only through the prism of supply. If the money supply contracts, each unit becomes more valuable and if the money supply expands, each dollar becomes less valuable. That is obviously not happening right now if you look at Fed charts (that is, the money supply expanding), as banks are restricting credit, and hoarding capital. Most analysis forgets the demand side of money. The demand for dollars is going down faster than the supply is contracting.

    Why is the demand for dollars going down? Well what can you buy with dollars that isn't going down in value? Stocks, bonds, mortgages, treasuries (no real returns because interest rates are so low) are all declining in real and in most cases nominal value. But foreigners have so many dollars that are depreciating daily, so what do they buy? The only things settled in dollars that are maintaining their value, commodities.

    So we have the combination of deflation at a rate less than the drop in demand for the dollar, which makes anything bought in a global market more expensive, and thus the 'illusion' of inflation. This is the problem with calling what we are currently experiencing inflation.

  2. You should read Mish over at

    He's provided the most trenchant case for deflation that I've read.

    He has a number of superb posts on deflation. I recommend checking them out.