Disinflation Alert

Marketwatch reports:

Consumer prices in the United States fell 0.1% on a seasonally adjusted basis in April as energy, housing, auto and apparel prices declined, the Labor Department reported Wednesday.

It was the first decline in the consumer price index since March 2009. The consumer price index is up 2.2% in the past year.

The core CPI -- which excludes food and energy prices in order to get a better view of underlying inflation -- was unchanged in April, lowering the year-over-year increase in core inflation to 0.9%, the lowest rate since January 1966.

The report was better than expected. Economists surveyed by MarketWatch nailed the 0.1% drop in the headline CPI, but were expecting a 0.1% gain in the core rate. See our complete economic calendar and consensus forecast.

Not sure how a negative print and a 0.9% year over year core print are "better than expected"; to me this is a sign of disinflation (or potential deflation). Not only was the year over year core the lowest level in 44 years, but the rate will likely be headed lower in the near future due to all the concerns that are causing a flight to the dollar (an increase in the value = a decrease in the cost of goods / services all else equal).

First details of the latest headline print showing almost all "inflation" remains in transportation costs.



And details of transportation price increase show they are almost entirely concentrated in fuel.

With a 15% drop in the price of oil over the past month and more favorable year over year comparisons going forward, expect the headline rate to come down further in the coming months.

Source: BLS

Business Loans Record Freefall

We have detailed the deflationary pressures from low capacity utilization and high unemployment before, but John Mauldin details the deflationary pressure coming out of an area that was / is supposed to power the U.S. recovery... businesses. We have detailed the pullback in new loans to consumers, but below shows the reduction in business loans. First to John Mauldin:

Then we have Reduced Borrowing and Lending, as consumers are paying down debt and banks are reducing their lending. Both are necessary in a credit crisis-caused recession. Bank lending is basically back to where it was two years ago, and shows no sign off rebounding. Banks, as I have written, are buying US government debt in an effort to shore up their balance sheets. Lending to small business, the real engine of job creation, is sadly decreasing eachmonth.

The chart below shows the year over year change in business loans as a percent of GDP going back 6o years.



A record drop and this one doesn't yet appear to be slowing down.

Source: BEA / St. Louis Fed

Deflationary Spiral in Japan?

Bloomberg reports:

Japan’s consumer prices fell at a record pace in August, heightening the risk that prolonged deflation may hamper the country’s recovery from its deepest postwar recession.

Prices excluding fresh food slid 2.4 percent from a year earlier, topping the previous month’s 2.2 percent decline, the statistics bureau said today in Tokyo. The drop matched the median estimate of 28 economists surveyed by Bloomberg News.

Companies from Fast Retailing Co. to Sony Corp. are lowering prices to attract consumers who face record unemployment and plunging wages. A return to deflation that the economy only shook off in 2005 may weigh on growth as consumers and companies cut back spending in anticipation that prices will keep falling.

“We’ll soon start to see that there isn’t enough domestic demand to push up wages,” said Kyohei Morita, chief economist at Barclays Capital in Tokyo. “As households’ spending power falls, there’s concern that this deflation will lead to further deflation -- in other words, that we’ll enter into a deflationary spiral.”

Source: Stat.Go.JP

When Falling Prices "Aid" Confidence

Missed this yesterday. BBC (via Credit Writedowns) details:

German consumer prices fell for the first time in 22 years in July, official figures have shown. Prices fell 0.6% in July from a year earlier – the first fall since March 1987, when they declined by 0.3%. The decline was largely due to falls in energy prices, which peaked in summer 2008, and analysts said Germany was unlikely to see a deflationary spiral. Prices can fall for a short time without hurting the economy, but prolonged declines can be damaging.

Dirk Schumacher, an analyst at Goldman Sachs, said that the falling prices could help the economy in the short term. "Falling prices are aiding consumer confidence and purchasing power. That’s aiding consumption," he said."This is not deflation. We’re still far away from that. It’s no cause for alarm," he added.

Back to Ed from Credit Writedowns:

Right. Keep telling yourself that.

Prices are falling. This is deflation and it should underline for anyone with half a brain that deflationary forces of demand growth declines, deleveraging and overcapacity are still at work.

Source: DeStatis.DE

Deflationary Cycle: UK Edition

ITV reports:

The headline rate of inflation, which includes mortgage payments, has fallen below zero for the first time in 50 years.

RPI stood at 0.4 per cent last month - down from zero in February - showing the cost of living is actually getting cheaper.

But negative RPI should not necessarily be welcomed. The figure is often used as a benchmark to set wage, state pension and other benefit increases.

That last sentence is striking. According to Save Borrow Spend:

Millions of public sector workers could find their incomes on hold if the UK enters a period of deflation. Council workers, nurses and teachers could all see their pay cheques stand still because public sector pay is tied to the RPI.

Let the deflationary cycle begin.

Source: Statistics.Gov.UK

Import / Export Prices

The latest BLS release for U.S. Import and Export prices shows a rebound from the deflationary pressures we've seen since the turmoil began in early Fall:

Imports

Import prices fell 1.1 percent in January and 23.4 percent over the past six months. For the sixth consecutive month, petroleum prices and nonpetroleum prices decreased, falling 2.4 percent and 0.8 percent, respectively, in January. However, prices for both overall imports and petroleum decreased at a smaller rate in January than in each of the previous five months since prices last rose in July.

Exports

Export prices rose 0.5 percent in January after declining in each of the previous five months. The increase was driven by a 6.2 percent rise in agricultural prices as nonagricultural prices were unchanged. The rise in agricultural prices followed decreases in four of the previous five months. Higher prices for corn, soybeans, and wheat accounted for the increase in January. Despite the January increase, agricultural prices fell 9.7 percent over the past 12 months. Nonagricultural prices recorded no change in January after falling in each of the previous five months.

Deflation Worries Easing?

Paul Krugman posts a chart that he believes shows a strong relationship between an output gap and deflation, while Paul Kedrosky implies that same chart shows randomness. So which is it... inflation or deflation?

CPI swap expectations have moved from north of 3% as recently as last May to negative (i.e. expected deflation over 2 and 5 years). Since mid-December, they are all beginning to reverse course. In other words, the market can't figure it out either.

Deflation: Front, Center, and Even Down Under

Across the Curve details some more deflationary news:

Australian consumer prices declined 0.3 percent in the most recent quarter after rising 1.2 percent in the previous quarter. It was the biggest drop in the index in 11 years. Leading Indicators in Australia fell 1.0 in November to 253.5. Toyota, Honda and Nissan slashed global production last month by 25 percent, 7.5 percent and 36 percent, respectively.

While longer term (i.e. at some point), I view the all the stimulus as inflationary, those trillions of dollars are no match for a global slowdown in the short-run.

Producers Price Index Breakdown (December)

Year over Year



Month over Month



Historical Year over Year

Source: BLS

Break-Even "Deflation"

Inflation Swaps are currently pricing in "expectations" of deflation of 1.5% over 2 years and inflation just over zero over five years. Ten and twenty year numbers are both well below 2% each.


U.S. TIPS price in a much greater chance of deflation as hedge fund unwinds and a flight to liquidity have put extreme pressure on the TIPS market (per Bloomberg).

The breakeven rate, or the difference in yield between two- year inflation-protected and nominal debt, suggest traders are betting the economy may face deflation over the next two years. The two-year breakeven rate was minus 3.96 percentage points.

Also an interesting point from Robert Barrow (via Greg Mankiw):

The basic idea is that, in the present environment, nominal Treasuries have a negative beta. If we go into Depression, the expectation is that this will be accompanied by substantial deflation, so that Treasuries will do well in real terms. In contrast, the typical pattern is different--perhaps bad times are usually accompanied by high inflation or at least average inflation. Therefore, especially at the shorter end, the relation between indexed and conventional Treasuries has shifted--the real rate on indexed bonds now has to be well above the expected real rate on nominal bonds.

We Present a Positive Aspect of the Recession

Forbes:

The price of Maine lobster, which accounts for 80 percent of the U.S. catch, is tanking.

The primary factor, a drop-off in demand by penny-pinching diners, has been in place since summer. But a secondary problem recently surfaced: the global banking crisis left Canadian processors short on credit, trapping Maine lobstermen and dealers with too much supply.

Along the Portland waterfront, seafood shops are selling lobsters for as cheap as $3.89 a pound, which is about the price of bologna at the deli counter.

Nominal vs. Real GDP: Why the GDP Deflator Overstates GDP

To better illustrate the impact of the Import GDP Deflator on Real GDP, the chart below shows Real vs. Nominal GDP by component.

First, a refresher... the greater the size of net exports, the greater the GDP. Net exports = exports less imports, thus an increase in imports negatively impacts GDP all else equal.

So what do we find? Nominal imports increased in Q2 by 18.8% annualized. Real imports DECREASED in Q2 by 7.5% annualized. In other words, even though we paid 18.8% more out of our pockets, we received 7.5% less units of these imports. Why? The Import GDP Deflator decreased imports by more than 25%.

Is paying more for less beneficial to our economy? No... but it is good for GDP. As detailed here, this 25% contribution by the import portion of the GDP Deflator increased Real GDP by a positive 4.6% (Imports make up roughly ~1/6 of GDP). Had we paid the same price level quarter over quarter for our imports, and thus received more given the level of nominal GDP, real GDP would have been -1.3% (I understand this WOULD NOT necessarily be a more accurate version of GDP, but it illustrates the size of the impact / just how odd this calculation is).

Ignoring the odd calculation, does this make sense to me? It doesn't. For this to make sense, it must be reasonable that we imported 39.2% less petroleum products during the quarter (in real terms) on an annualized basis. If the U.S. was able to drop its dependence by that much in just one quarter, I guess the U.S. isn't nearly as dependent on the Middle East as we thought. More important, it implies that the U.S. economy is stronger because we paid more in aggregate for our imports, but received less units as more was consumed from non-imports.

Want to hear something more likely? The impact of import inflation on the GDP Deflator is too high and GDP is overstated.

GDP ex Import Inflator: Third Straight Quarter of Decline

Due to a rise in the price of oil from less than $110 to $145+, the import portion of the GDP Deflator Inflator raised Real GDP by 4.6% (what is the GDP Deflator? click here). This is more than 2x the level seen at any other point during this decade and the highest amount EVER (we have to go back to Q1 1974 and Q1 1980 for levels even remotely close to that of this past quarter).

Had the contribution of imports on the GDP Deflator Inflator stayed the same as last quarter (which was historically large), GDP goes from the 3.3% as reported by the BEA to 0.9% for Q2. If the deflationary impact of imports were removed completely from the equation, GDP goes to -1.3% and shows GDP contraction for the third straight quarter.


Which sounds more reasonable to you?

Source: BEA

The Real M1 and M2 Money Supply

Yves at Naked Capitalism recently detailed the steep drop in the M3 Money Supply, but rewinding a month back, she first asked Does M1 and M2 Contraction Signal Debt Deflation? Specifically:

Many have criticized the Fed for "printing money" of late. But the evidence suggests otherwise. First, all of the cash injections that the central bank has undertaken via its alphabet soup of new lending facilities have been met with roughly equal withdrawals though open market operations. Thus the new facilities themselves have not led to monetary expansion.

Looking below at the real M1 / M2 money supply (the supply discounted by the CPI Index), we can see that the historical "real" increase in the M1/M2 money supply has all, but ceased since the credit contraction set in a year ago (it has actually decreased).

Zooming in...



More fodder for the deflation side of the growing inflation / deflation debate.

Source: Federal Reserve

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.

SHELTER:

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:

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 / FOOD / COMMODITIES:

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?

RECESSION:

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.