Sunday, January 18, 2009

False claims of deflation

We may at some point start to experience true deflation, but it is not here yet. The recent "headline" declines in inflation are simply an unwinding of the price spikes that we saw earlier last year as energy, food, and other commodities prices that were pushed up by speculation rather than true demand. The whole point of measuring inflation is to measure actual demand relative to actual supply. That means we need to factor out mere speculation. This is typically done by focusing on "core" inflation, which factors out energy and food prices. The theory is that any long-term food and energy price changes (free of speculation since speculation is a relatively short-term phenomenon) will eventually flow back into the prices of other components of consumer prices.

Core inflation was +1.8% over the past calendar year. That was in the CPI report, but conveniently overlooked by those who are touting deflation due to some agenda they are pursuing but not disclosing.

Even with the speculative price swings of food and energy included, there was no deflation on a year over year basis (+0.1%.)

The headline consumer price declines since July perfectly bookend the headline price increases that we saw leading up through July. Those two artificial trends (due to speculation up through July and the unwinding of speculation since July) are not in any way an indication of any true, long-term trend or true, long-term inflation or deflation.

It may take another two to six months to wring all of the speculation price gains out of the headline inflation number, and we may see modest declines in core price changes as the lower energy prices gradually flow into the other components of consumer prices.

One technical problem is that even though energy prices fell sharply since the middle of July, real users such as transportion companies and chemical companies may have purchased futures contracts many months out into the future at those artificially inflated prices and those high prices will need to be factored into the prices of their goods and services now and maybe months into the future. Most of the impact of those higher prices should be wrung out of the system over the next few months so that six months from now core prices will reflect current energy and commodity prices.

It is also worth noting that energy prices are now bouncing around within a much narrower range over a much shorter timeframe, as they have done traditionally.

Unless crude oil falls well below $30 and heads below $20, we are unlikely to see true deflation over the next year.

Unemployment would probably need to head above 12% as well to see the kind of demand decline needed for true deflation to take root.

-- Jack Krupansky

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