The Deflationary Shock
The Pragmatic Capitalist has a very good comment on David Rosenberg's market letter this morning. I agree with practically everything in this post.
THE DEFLATIONARY SHOCK….
22 February 2011 by Cullen Roche
David Rosenberg makes some interesting comments in his morning note regarding the price action in US Treasuries. He cites the rally as a sign that the world is concerned about the deflationary shocks from rising oil prices:
“It is also interesting to see how government bond markets are reacting to the oil price surge — by rallying, not selling off. In other words, bond market investors are treating this latest series of events overseas as a deflationary shock.”
I think Rosey has this one spot on. The risk of rising oil is not a hyperinflationary spiral, but rather a deflationary spiral. Oil price increases are cost push inflation of the worst kind and for a country still mired in a balance sheet recession that means spending gets diverted which only gives the appearance of inflation in (highly visible) gas prices while creating deflationary trends in most (less visible) other assets (have a look at today’s Case Shiller housing report for instance).
The environment is not really so different from what we were experiencing in 2008. What we have in the USA is an underlying balance sheet recession being papered over by government deficit spending and very easy monetary policy. The math behind our economic plight is quite simple. Since we are running a -3% current account deficit the government must spend to the tune of 3% of GDP if the private sector desires to save. And that’s exactly what is occurring. In fact, the 10% deficit is allowing the private sector to save quite a bit (roughly 7%). Make no mistake, the deficit spending of the last 2 years is what has generated recovery. This is far from organic growth, but as we learned in Japan and during the Great Depression, the alternative is to risk something worse. Unfortunately, our implementation of the recovery plan has been mangled at several steps along the way so it is primarily Wall Street that has benefited while Main Street continues to suffer. I attribute this lopsided recovery in large part to the actions of the Fed.
The Fed’s dual mandate has them tinkering in the markets far more than they should and the repercussions are disastrous psychological impacts. They manipulate rates, bailout the banks, and generally implement policy that is based around creating a healthy banking system. After all, that’s really all their tool set can do anyhow. Not surprisingly, their policies over the last 20 years have helped in significantly financializing the US economy. The results of that world speak for themselves.
Today, in a misguided attempt to create a “wealth effect” via equities it appears as though Ben Bernanke has helped to generate a speculative boom in many commodities. This is not the direct cause of the unrest abroad, but it’s certainly not helping. But perhaps more importantly, the environment that Ben Bernanke is creating (commodity bubbles) actually increases the risk that we will relapse into a deflationary spiral (the very thing he is attempting to combat). After all, if the global economy slows once again it is highly likely that we will see price action that was very similar to 2008 – a flight to safety in US Treasuries, USD, commodities get crushed and equities sell-off. Today’s action is a small example of that sort of fear trade. And make no mistake – this is not hyperinflationary price action. This is deflationary price action.
For now it still appears as though the US economy is strong enough to generate low single digit inflation, however, if the commodity bubble were to worsen or oil prices were to cause a global recession (this looks increasingly likely as we head into summer) we are likely to find ourselves revisiting our deflationary discussions as opposed to fears over hyperinflation. This is not the 70′s and it is most certainly not Zimbabwe or the Weimar Republic. This is still an environment more akin to Japan and the 30′s.