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Home > Blogs > Anthony Harrington > US economy - is deflation a "straw man"? Probably not!

US economy - is deflation a "straw man"? Probably not!

US economy - is deflation a Anthony Harrington

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For every optimist on the subject of the US economy you can probably find two pessimists. What is certain is that July saw a sharp upturn in new housing starts. As James Picerno writes in his CapitalSpectator blog, while housing has been one of the weakest parts of the US economy lately, the latest housing starts figure, released on 18 August 2014, for July 2014, was substantially better than expected:

"Housing starts revived to a 1.093 million annualized rate (in July), which is well above the revised 945,000 pace for June. Newly issued building permits also posted a strong improvement in July. The bottom line: the worst fears for the housing sector have crumbled [...] Today's new boost the odds that the US macro trend will perk up a bit."

Against the backdrop of what looks like a deepening weakness in major European economies, any good news on the US front has to be welcomed. Picerno says that starts and permits are now advancing at a year-on-year pace that, in his words, "are near the best levels in recent history". However, despite his enthusiasm, the rate of growth in new housing starts slowed perceptibly through May and June so July's pick up, though welcome, needs to be confirmed over the coming months.

Interestingly, as the stocks blogging site, Notes from the Rabbit Hole (NFTRH) points out in a recent post, the US displays a long running and rather dysfunctional disjunction between inflation and bond prices. The Fed has been fighting deflationary scenarios since the great financial crash of 2008. Pumping huge amounts of money into the economy was designed to stimulate the economy and avoid a deflationary depressive cycle. All this pumping had to boost inflation somewhere in the economy and the one place that rising prices have really turned up in spades, NFTRH points out, is in stock prices. The S&P hit yet another all time high in the week ending 22 August and seems likely to go through the proverbial 2000 barrier any day now. Consumer Price Index (CPI) inflation, however, has stayed stubbornly beneath the Fed's target of 2% and is only now, after six years of quantitative easing, starting to nudge that target.

What is supposed to happen, as CPI goes up, is that it is supposed to trigger demands by bond investors for at least a corresponding rise in bond rates to compensate them for rising inflation. However, NFTRH points out that if you look at graphs of the ratio of bond rates over CPI prices since the year 2000, you can draw a strongly downward sloping line from top left to bottom right for 10 year, 5 year and 2 year Treasuries. By way of contrast if you go back to 1981 and graph the rise of CPI from then till 2014, you get a pretty steep rise from around 75 on the scale in 1981 to 237 on the scale today. What this shows, the NFTRH blog argues, is a bond market that refuses to do anything in the face of a near constant rise in CPI.

Zachary Karabell, the author of "The Leading Indicators: A Short History of the Numbers That Rule Our World", writing for Slate Magazine argues that many economists and central bankers are missing a fundamental point, namely that as he puts it:

"[...] the current trajectory of the global economic system trends toward price stability verging on deflation. That is a dramatically different world than the one we have recently emerged from, namely a 20th-century world defined by industrial nation-states and closed financial systems where price shocks, volatility, and inflation posed ever-present threats that demanded vigilance."

The only countries in the world where rising inflation is an issue right now are Brazil and India. China's inflation is now down to around 2.5% despite its 7% growth rate. Containing inflation was the challenge of the last century, the challenge of the current century is all about learning to live with modest rates of global growth and potential deflation, he argues. From that standpoint, the story being told by NFTRH's graphs of US Treasury prices is that bond investors have it just about dead right. In a near deflationary world, getting your principal more or less intact, is a win.


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Tags: CPI , deflation , European economies , Federal Reserve , housing market , inflation
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