Deflation: Really?

April 17 2014

There is a public outcry over lower inflation. Many pundits fear deflation, as if it was the devil himself. IMF’s Christine Lagarde is one of many alarmists that warn for a deflationary spiral, calling it the deflation “ogre”. Lagarde has been very outspoken about the dangers of falling consumer prices and even urged ECB-president Mario Draghi to actively “fight low inflati

Deflation: Really?

There is a public outcry over lower inflation. Many pundits fear deflation, as if it was the devil himself. IMF’s Christine Lagarde is one of many alarmists that warn for a deflationary spiral, calling it the deflation “ogre”. Lagarde has been very outspoken about the dangers of falling consumer prices and even urged ECB-president Mario Draghi to actively “fight low inflation.” Besides that falling prices are nothing to fear, it’s very unlikely we will have a prolonged period of falling prices.

Falling Consumer Prices Unlikely; Food Prices Soaring

Food prices have recently been soaring on futures markets. Orange-juice futures, for instance, have risen this week to a two-year high. Beef prices have peaked since February to a 14-year high and pork prices spiked in a similar fashion. Not just meat is seeing price increases, sea food is getting hit as well: shrimp prices are rising fast and jumped to a 14-year high in recent months. In addition, corn prices have soared in the first quarter of this year with over 18%, while wheat prices have risen as well, going up almost 15% in Q1. Coffee was no exception: the most consumed beverage in the world already went up over 50% in 2014.

Such price increases can be somewhat mitigated by declining producers’ margins, yet we generally expect some price increases to be passed on to the consumer. Previously, food prices have soared while not all costs were passed on to the consumer. As a result, little space may be left for retailers to bargain such a postponement of price increases: producers might be incapable of further reducing gross margins.

Food and beverages comprise about 15% of the entire inflation headline number. Of course, human beings that do without beef, pork, shrimp, bread, or corn are likely to remain uninfluenced: according to the Fed, affordable bacon is something very scary. As some amusingly speculate on what Fed-officials might say when confronted with higher food prices: “Let them eat iPads!”

But, of course, according to the Bureau of Labor Statistics, we have nothing to worry about, as they simply make “hedonic-adjustments” to an alleged representative basket of consumer goods, a stark difference with the methods used for measuring price inflation before. No fixed basket here.

The Biggest Component of the US Consumer Price Index

The biggest component of the consumer price index is, however, the owners’ equivalent rent (OER), which represents the cost of shelter. Indeed, the (median) asking rent for vacant units is still on the rise and will probably not slowdown anytime soon. The OER is actually on the highest level since 2008, a sign that declining consumer prices are not something we have to worry about anytime soon.

Indeed, mortgage originations have fallen sharply and mortgage rates were heading up quite substantially. Any slight change in interest rates has a disproportionate effect on housing demand. All the while rental prices are increasingly sharply due to higher rental demand.

Yet the Fed generally points at the “PCE deflator” as an indication of price inflation, which underweighs the OER enormously, representing only 11.3% of the Fed’s metric of preference. It appears the Fed even considers shelter as something that can be simply adjusted away, as if human beings could live without. Perhaps they might consider a “hedonic-adjustment” down the line, by replacing shelter with the cost of a cardboard box. “Let them eat iPads!”, again.

Inflation and Deflation Are Not About Prices

Okay, so the threat of deflation is not imminent. But even if it was, there is nothing scary about falling prices. It is plainly wrong to argue that there is something like a “deflationary spiral” for consumer goods. We had large prosperous episodes in the history of the world during which consumer prices were falling. Consumer prices ought to fall. As we get more productive, products get more abundant and prices fall. Nobody will buy birthday presents six months afterwards because prices are falling, or stop eating as the price of food gets cheaper, nor delay the purchase of computers even though they get cheaper every year.

What we did experience was an enormous expansion of credit since the turn of the millennium, as central banks held down interest rates to an extent never seen before. Such an expansion of credit unbacked by real savings (resources are scarce!) led to economic disaster, as price signals got distorted and eventually resulted in a full-blown financial crisis. What we are experiencing right now is a deleveraging, a necessary economic cleansing after the excesses of cheap money. Financial excesses arose not because of greed, or because people have become greedier along the way, but because the Federal Reserve persisted in an unprecedented period of low interest rates (negative, even, in real terms) and balance sheet expansion.

The risks today are reckless fiscal and monetary policy, not the necessary deleveraging we are (to some extent) going through for the past few years. Bad investments made during the boom times are being liquidated and taken over by others, moved into other lines of production that do make sense economically. We are going through a necessary phase after years of reckless government spending and bank lending, and that means some asset prices will inevitably fall (such as real estate in many markets around the world).

No Science Involved

There is no scientific way to determine consumer price levels. Consumer prices are continuously in a state of flux. Any choice for one basket over another is per definition arbitrary. In other words, the favorite metric of the Fed is just as scientific (or, better said, as arbitrary) as the basket followed by the groceries-buying housewife.

That is not the only arbitrary metric central bankers apply for policy decisions. The 2% inflation rate, considered the “right” inflation rate, is also an arbitrary number plucked out of the air.

So we measure consumer prices arbitrarily and then decide, again, completely arbitrarily that these arbitrarily measured consumer prices should increase, for some reason, 2% a year. I can assure you there is no scientific basis for the consumer price index nor the 2% inflation target of central banks.

Gold and Deflation

Some argue that if there was a deflation, we should sell our gold and hold dollars (or euro’s) instead. However, if at a certain point in time consumer prices do decline, it is most likely a result of the global deleveraging, not of improving productivity and a greater abundance of goods.

It is first and foremost asset deflation. And that would generally mean bad news: balance sheet write-down’s by banks, sovereign defaults, bank failures, and/or collapsing markets. It is quite possible that even then gold will outperform all other assets in nominal terms, and as a consequence even to a greater degree in real terms, if and when the world falls into a deflationary collapse. Yet, as you might recognize, there no question of a deflationary collapse simply because consumer prices would fall, but because the deleveraging would be much more painful than many right now seem to think. We will have asset deflation, not just price deflation.

Inflation or deflation: it’s relatively unimportant for gold investors. Smart gold investor should instead focus on the unsustainable debt levels around the world and the accompanying deleveraging that will come to pass some way or another.


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