Tuesday, July 14, 2009

The deflation dog that didn't bark

Given how miserable the economy has been, and considering the prevailing view that significant economic weakness is a source of deflationary pressures, many observers were likely quite surprised this morning when the government announced that the Producer Price Index jumped 1.8% in June, and is up at a 4.2% rate so far this year. The core (ex-food and energy) PPI index was up 0.5% in June and is up at a 2.0% rate year to date. Both measures of producer prices rose far more than expectations in June.

One big and overlooked story this year has been the failure of deflation to appear. Recall that by the end of last year the market was obsessed with deflation risk; TIPS breakeven spreads were priced to the expectation that inflation would be negative for many years to come. Well, it hasn't happened—in fact, just the opposite. This is big news.

I've been emphasizing this for many months now, since it leads to some very interesting conclusions. For one, the evidence is disproving the Fed's theory of inflation; that in turn means that the Fed has probably been too easy because they've been overly concerned about the risk of deflation. With no shortage of money (another favorite theme of mine since last year), it is hard to see the economy going down the tubes. Two, rising prices are likely reflecting rising demand in addition to an abundance of money; that means the economy is probably doing better than most people give it credit for. Three, T-bond yields are probably underestimating future inflation, and that means yields could continue to rise as the year progresses. Four, an abundance of money coupled with rising demand is very good news for all those companies and countries with lots of debt, since it increases their expected future cash flows. It's not surprising therefore to see that credit spreads have contracted significantly and emerging market debt has done very well this year.


Gene Prescott said...

At the risk of being yet another poster hi-jacking your blog, I note that one large bank, BAC, is giving a "very credit worthy" client (housing industry) fits in renewing a decades old line of credit relationship. This client is bankable without any stimulus funds .... yet a bank greedy at the stimulus trough is playing russian roulette seemingly because nobody has the authority to make an actual decision.

alstry said...

Failure of Deflation to appear???


Every worker for the State of California is facing a 20% wage cut....and the government cuts are just beginning.

IT workers, especially independent contractors, are facing similar cuts.

Airline workers are making a fraction of what they used to....

Same with auto workers.....as well as other manufacturing jobs.

Mortgage brokers and Real Estate sales people are barely scraping by...

Trucking rates are off double digits and many truckers are simply shutting down.

Never in American history have so many been forced to suffer such massive wage reductions in such a short period of time.

Hence, retail sales are DOWN 10% year over year based on my early July feedback, conditions are deteriorating. Not only is retail evaporating, housing prices are off 50% and more in many areas with little sign of relief as distressed sales are continuing to make up a growing percentage of sales?

No deflation?.....maybe in a few areas......but real problem rests for a consumer based economy where wage deflation is kicking in at fastest rate in history.....add in the backdrop of unprecedented debt and we have a recipe for disaster.

Pay attention to upcoming transportation revenues and bankruptcies in this quarter...the numbers will be SHOCKING.

__ said...

Alstry, I will again ask that you back up your claims with some data. And to borrow from someone wittier than me, "the plural of anecdote is not data".

Gene Prescott said...

INTC beats: http://bit.ly/CFVrU

alstry said...


Everything I just posted is common knowledge.

As far as the 20% state worker cut, you can pick up just about any SacBee or L.A. Times.

IT workers, just read today's WSJ or go to the WSJ online.

Airline workers....just ask any pilot, flight attendant, or ground worker next time you take trip. Personally, pilots make great drinking buddies.

Auto workers or manufacturing jobs...you would have to be living under a rock to be ignorant of this.

Trucking.....just take a look at CSX's numbers yesterday or CHRW's payments to vendors.

Remember, the wage reductions do not include the income reductions to 25,000,000 Americans who are classified as unemployed by U6 data....and you can confirm that at the Department of Labor website.

Hopefully, that satisfies your request for data.....

Mark A. Sadowski said...

First of all a minor correction. Core PPI is up at an annual rate of 2.0% so far this year not 2.4% (I watch these numbers very closely).

Second, this does not at all violate the Fed's current model. The Fed is currently under the assumption that inflation expectations are well grounded at 2%. Nothing in this latest report suggests that that model has been violated.

Scott Grannis said...

Mark: I stand corrected. Core PPI is up at a 2.0% rate year to date. Evidently I missed a revision to the series earlier this year.

I did not say that this data invalidates the Fed's model, only that it casts doubt on the model since in the midst of a very weak economy and with all the Fed's concerns about deflation, there has been no appreciable weakening in the core inflation data as the model would have predicted. I said in an earlier post that if this keeps up for the rest of the year, then the Fed is going to have some explaining to do.

Scott Grannis said...

Gene: I suppose it is the case that while money is in abundant supply, credit is not freely available. The two are very different animals. We are still working our way out of last year's credit crisis.