Wednesday, August 14, 2013

Is it inflation or deflation?

Although European stock markets moved higher today on second quarter GDP data that showed that Europe is emerging from a six-quarter-long recession, our markets were surprisingly weak.  I attribute the price action to a normal consolidation after the incredible run up the market has had.

Still, the Retail Sales data yesterday was flat and a case could be made that if it weren't for higher prices at the gas pump the report might have been negative.

Of greater import to me was the PPI (producer price index) data today.  The PPI measures the average change over time in the prices received by domestic producers of goods and services.  The index came in flat versus an expectation of a 0.3% increase.  Moreover, the year over year change for the index less the volatile food and energy complex is running at only 1.2% versus June's 1.6%. 

The market is more fixated on the CPI (Consumer Price index) which is set to be released tomorrow.  The CPI is already running below the Fed's target rate of 2% and is reflective of the disinflationary pressures the US economy has been enduring.

Up to this point the Fed has dismissed the low inflation numbers as "transitory".  Jim Bullard of the St. Louis Fed is the only governor who has raised concerns about it and was grudgingly afforded a blurb in the latest FOMC announcement, mostly to placate him.

Regular readers of my commentary know that I have been concerned about global deflation and the recent disinflationary trends in this country for some time.  My most recent commentary in which I addressed these issues can be found here: http://equitymaven.blogspot.com/2013/07/of-central-banks-asset-bubbles.html

The following is a weekly ratio chart of the iShares Barclays TIPS Bond ETF (TIP) divided by the iShares Barclays 7 to 10 Year Treasury Bond ETF (IEF):
 
(click on chart for larger image)
 
The concept behind the chart is that TIPS are Treasury Inflation Protection securities that are indexed to the Consumer Price index (CPI) in order to protect investors from the negative effects of inflation.  When TIPS outperform Treasury Notes or Bonds, investors are anticipating a higher rate of inflation and are fleeing to a vehicle that will protect them from anticipated inflation.  When TIPS under perform, investors are more than willing to park their money in regular Treasuries which, at this time, are yielding in many cases a negative rate of return.
 
 
You can see from the chart above that the ratio swooned going into 2013 and accelerated into late June (black arrow) when we got a bounce.  Now, however, there are signs it is once again rolling over (red arrow).
 
 
In a fiat money system with unlimited credit creation, inflation is a necessary and required by product of healthy economic activity.  Indeed, in such a system, inflationary pressures are indicative of a healthy, growing economy.  That's why the Fed targets a 2% inflation rate. 
 
Here's another chart that's reflective of the lack of inflationary pressures in our economy.  It is the Velocity of M2 Money Supply:
 
(click on chart for larger image)
 
This is the lowest reading since statistics were taken on this metric in 1958!  I know regular readers of my commentaries and blog are sick of seeing this chart but I continue to post updates because it is very relevant to the topic at hand.  Velocity measures the number of times one dollar is spent to buy goods and services per unit of time.  This chart verifies what the first chart is telling us: there is no inflation in this economy to speak of and I would submit that if things don't change soon the Fed may have become trapped into a classic liquidity trap.  Characteristics of a liquidity trap are short-term interest rates that are near zero and fluctuations in the monetary base that fail to translate into fluctuations in general price levels.
 
 
The TIP:IEF ratio bares watching.  I consider the disinflationary pressures we are now seeing in this economy as the greatest impediment to the kind of post crash recovery we all yearn for. 
 
Hopefully, gold's recent pop is foretelling that we will see a turn around soon.