Thursday, March 4, 2010

Inflation AND deflation

Over at his blog, Tim Duy is worried about the risks of persistently low inflation or deflation and asks if the Fed is underestimating the macro risks of deflation. He concludes that:

[T]he Fed did find ways to maneuver around the zero bound constraint this time, I am more concerned with the next recession than this one. Recent history suggests that each recession necessitates lower interest rates than the last. I would prefer to pull the economy up to a point where we had some distance from the zero bound such that we did not have revert back to managing economic activity via ballooning the balance sheet. And while the balance sheet proved to be an effective tool for defrosting frozen financial markets, would it be as effective if the next time around the problem was simply too little demand in the presence of functioning financial markets? I would rather not endure the experiment.

What do you mean by inflation?
I firmly believe that central bankers are looking at the issue of inflation and deflation in the wrong way. The Cleveland Fed has median and trimmed-mean CPI figures that show that inflation is well under control. The Dallas Fed has a trimmed mean PCE that tells the same story.

If central bankers monitor these kinds of core inflation measures, they will conclude that inflation is well under control.

The alternative view is that global monetary and fiscal authorities are engaged in synchronized prime pumping policies that amount to competitive devaluation. However, because the stimulus is more or less synchronized, devaluation pressures aren’t showing up in the forex markets but in the commodity markets. So when central bankers analyze core inflation statistics, which is ex-food and energy, or trimmed mean inflation-like statistics, commodity inflation doesn’t show up because that the precise segment that’s getting excluded.

Different kinds of risks
I agree with Tim Duy that the macro-economic risks of deflation are higher than what the consensus is. I would add that the risk of inflation, in particular commodity inflation, is also higher than anyone expects.

That’s why my Inflation-Deflation Timer model focuses on commodity inflation as an indicator of inflation for investors.

1 comment:

The joker said...

Hi Cam Hui,

I do agree to your view point that near simultaneous stimulus by most of the countries means we may not see much movement on forex. Again I agree to what you say that we may see some inflation in future on commodities, but will that mean general inflation?
No, because what you are not factoring here is that technological advancement in most of the fields are now happening at even alarming rate. What does that means? Do resources or commodity get destroyed once we use them? no. They get transferred to their derivative form which is difficult to use once its core purpose is served. But now technology is making a difference here. Infact the productivity jumps due to technological advancement, I strongly believe, there is higher risk of deflation on a medium to long term basis, to what ever our current monetary or fiscal is, than inflation.