A Tsunami Is Coming, But Is It Deflation Or Inflation?

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:

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.