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A Tsunami Is Coming, But Is It Deflation Or Inflation? at Trader’s Narrative

There is an tsunami about to make landfall on the US economy. But will it be inflation or deflation? On the one hand we have deflation propelled by the crushing of commodity markets: oil, gas, gold, etc… as well as the massive real estate implosion across the globe.

On the other hand, consider all the inflationary agents:

  • loose US monetary policy the discount rate (as expected) being lowered to 1%
  • a loose fiscal policy (in an assumed Obama Biden administration)
  • a $1 trillion financial bailout
  • IMF bailouts of countries such as Iceland, Pakistan, etc.
  • loose monetary policy for all major central banks of the world

To muddy the waters even more, the US dollar has shot up to 2004 levels. Most would argue that a stronger dollar is deflationary. So amid all these cross currents, what can we expect as the net result? I’m not smart enough to wade through all the econometric data so I’ll let the market do that for me.

To get an idea of what the market thinks inflation will be we can look at the difference between the 10 year nominal treasury bonds and TIPS (Treasury Inflation-Protected Securities) which pay a real rate of interest. The difference between them is the forward implied inflation:

tips inflation expectations long term chart october 2008

For most of 2008 it estimated inflation at 3% but suddenly at the beginning of this month, it went into free fall. As of October 28th, 2009 it stood at -0.2945%. The bond market is clearly expecting the deflationary pressures to win over and win big.

The previous lows on the chart are for June 1998 and February 2001 when the estimate for inflation was 1.44%. Obviously we are in uncharted territory. Something that everyone is used to by now, no matter what metric or indicator we’re talking about. Looking back, in 1998 the Federal reserve reduced the Fed Funds rate from 5.50% to 4.75% by year end. And in 2001, the Fed slashed rates from 6.00% to 1.75%.

The difference with our current scenario is that the Fed had already started reducing rates. The Fed Funds rate was 5.25% way back in mid 2006 so at 1.00% where we currently stand, we are very late in the game. But they don’t have much choice since the other option is deflation.

We could even see the Fed turning Japanese and going for a zero or near zero interest rate. That possibility is more than plausible especially since the Fed’s wording hinted to their readiness to keep cutting. Japan amazingly avoided runaway inflation when they took their rates down to zero from 2001 to 2006.

If only the Fed had listened when the bond market was screaming for a rate cut back in 2007.

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15 Responses to “A Tsunami Is Coming, But Is It Deflation Or Inflation?”  

  1. 1 Purpleswan

    I think we will have deflation first. Which is what the markets are telling us now. But after that, we will have inflation - in other words, I am thinking there will be deflation in the short to medium term followed up super inflation.

  2. 2 buzgz

    In your list of things that will contribute to deflation, you leave out one of the most important: the massive tax increases on the most productive companies and individuals under an Obama administration.

  3. 3 mxq

    Jansen at across the curve had something very similar…his was an off the cuff of about -70bps inflation rate…see here.

  4. 4 Babak

    Purpleswan, that sounds reasonable. Isn’t the Fed wonderful? what would we do without these manufactured cycles? how boring would a stable economy be! the chart is saying that the bond market thinks for the next 10 years we’ll see an average of -.3% inflation. Now, that could change, but this is the message as of now.

    buzgz, the facts don’t bear out that assertion. It is actually the very opposite of what you suggest. Obama is cutting taxes for all. The only exception being the 0.1% of the wealthiest households and even then their taxes go up a measly 11% - assuming they can’t find better tax accountants. As well, Obama is removing capital gains taxes for businesses. Get the facts here and here (pdf).

    mxq, thanks for the link. I don’t see him actually saying anything about deflation. And his reference to 70bp is that the 6 month TIPS is saying that inflation will be +0.7% for the next 5 years appx. The chart above is for the 10 year TIPS as mentioned so the market in the long term is forecasting deflation for that foreseeable time frame. Not that it couldn’t turn on a dime as it has in the past!

  5. 5 Purpleswan

    Hi Babak:

    Where does one get this data on an ongoing basis to monitor this stuff regularly? I use telechart but they don’t track these indicators.


  6. 6 Adam

    I agree with PurpleSwan. One of the reasons for the strong dollar is central banks selling huge amounts of gold, providing ‘invisible’ liquidity. This artificial supression of prices coupled with vast increase in base money supply will whipsaw from deflation to something akin to hyperinflation in the long-term. unavoidable.

  7. 7 DaveinHackensack

    “the chart is saying that the bond market thinks for the next 10 years we’ll see an average of -.3% inflation.”

    How good a track record does the bond market have at predicting inflation over the long term? Judging from this chart, the bond market seems a little nearsighted.

  8. 8 Andi

    A quote from Cleveland Fed

    TIPS Expected Inflation Estimates
    October 31, 2008

    This series has been discontinued. We believe the method is not providing accurate estimates due to the unusual circumstances of the current financial environment.

  9. 9 R.D.

    Commodity comeback with a little more inflation ,then the K-wave swan dive to

    zool. ;)

  10. 10 Babak

    taking the other side of the argument: “TIPS may be broken

  11. 11 George

    The TIPS prediction might be more of what the CPI (which it’s based on) is expected to report rather than the real inflation rate.

    So it’s a question of how much inflation and how much “fudge factor” will go into CPI.

    And there are alternatives to TIPs, some with better tax rates/rules.

  12. 12 Babak

    Purpleswan, TeleChart doesn’t track econometric data. The best place to get this sort of information is directly from the Federal Reserve Bank(s). I cited the source for the above chart. But as you’ve read in the subsequent comments, they have cited the extraordinary circumstances as a reason to discontinue this data series for the time being.

  13. 13 buzgz

    Babak, Oboma plans to let the Bush tax cuts expire. If he does this it will be the largest tax increase on taxpayers ever.

    Now, find me a reference that says he won’t do this. Get your facts straight.

  14. 14 Babak

    buzgz, the Bush tax cuts were for only for the extremely wealthy, when you consider the Obama tax cuts for the +95% of the population, the net result is a small tax cut. As well, he is cutting other taxes like capital gains for small businesses, etc.

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