Inflation/Deflation.....

I will go out on a limb here and suggest that the current debate is the most divided ever on this topic, albeit with more participants in the inflation camp.

We actually do not have inflation at present - we have deflation as consumer prices (in the US) are -2.1% y/y (July 2009). German producer prices are -7.8% in the same month. These are unprecedented times as this phenomenon has not occurred since the 1940‘s.

Yet, the inflation scare mongers are abundant! Predicting that hyper inflation is just around the corner and comparisons with Zimbabwe are frequent, but where is inflation actually going to come from?

Unemployment is substantial, capacity utilization is low - it’s hard to see the theory of too much money chasing too few goods manifesting itself in the short to medium future. Ah, but I hear the inflation hawks say.........what about all the liquidity measures undertaken by the central banks and their destructive QE programmes - in effect printing money just like in Zimbabwe?

Well, that extra liquidity is in the main ending up with the same central banks that provided it in the first place in the form of extra reserves being placed on deposit with the central banks as there is little appetite for credit from creditworthy consumers and businesses and even less desire on the banks’ behalf to lend, which is why the monetary aggregates are not growing. US M2 growth is running at a seasonally adjusted annual rate of 3.2% in Q2 of this year - it is up 8.1% in july ’09 compared to July’ 08. These are hardly alarming growth rates.

At the same time when the public sectors are expanding their balance sheets the relevant private sectors and in particular households are shrinking their balance sheets - in the US this contraction far outweighs anything done by the Federal Reserve

Even with CPI falling 2.1% in the last year, producer prices are falling faster, which is why many of the large US retailers have been able to increase their margins in the last year as they have only partially passed on the decreases in the prices they pay to suppliers.

So with housing still declining (9.2% of all mortgages are now delinquent in one form or other) the job market is still getting worse as unemployment is expected to pass 10% this year in the US (official survey number - real unemployment is much higher) there will be no demand driven inflation.

So for inflation to come back it has to be caused by supply constraints and with capacity utilization at very low levels it is very difficult to see a scenario where that is going to occur, say for another oil price chock. This also looks less likely in a world that is awash with oil and short of places to store it. Last year’s spike to $147 was in effect driven by the Chinese accumulation so they could still run the Olympics had their traditional electricity sources failed them.

This year the Chinese have been stock piling again buying loads of raw materials and base metals etc, something you can do in a plan economy where no-one will get fired if it turns out to be a mistake and prices fall even further in the future. Now it seems to be over and the Baltic Dry Freight Index is heading back south again to where the freight rates for the finished goods (container shipping rates) are languishing, as these have seen virtually no recovery form the lows. Shipping rates are probably a better indicator of future inflation than so many other things and before they look like getting back to the levels of 2007, which was hardly a high inflation year, there is no need to worry.

Investors in index-linked bonds should pay heed to the fact that deflation can and will take a huge chunk out of the yield they receive. Break-evens can also go negative, as they were in Sweden in ’98.......