Be very afraid of the “D” word now making the rounds in economic circles. Today the Federal Reserve hinted that we are now tipping into the prospect of deflation. This is very bad from their perspective. In fact, it is a horrifying prospect for the Federal Reserve since every action they have taken in this decade has had the desired outcome of inflation. Why would the Fed want inflation? Inflation would make our structured debts cheaper as time goes by since the price level of most items in the economy would rise and the debt would remain static. First, let us get our definitions clear.

Inflation in the mainstream media is normally associated with a general price rise of items and goods in the economy. Conversely, deflation would be a general price drop in items in the overall economy. Many people from the classical school of economics or Austrian school refer to inflation or deflation when the money supply and credit move up and down. For our purposes, we will refer to the mainstream reference since most people are familiar with this and generally speaking in most normal times they usually go hand and hand.

Deflation is a troubling prospect especially for a society with so much debt. Why? What happens during a deflation is debts brought onto the books during high priced times are now more expensive as the general cost of other items in the economy goes lower. This is exactly what is occurring. Take a look at the Consumer Price Index (CPI) which just showed the largest one month drop on record:

The CPI measures a basket of consumer goods bought in our economy. This one month drop was enormous as you can see from the chart above but was largely due to the drop in fuel costs. Energy dropped a stunning 9% while transportation dropped 6%:

The fact that the Fed is only acknowledging this publicly now is a complete misnomer to the public. The true reality is that they were wishing deep down that inflation would make its way into the economy by the historical rate cuts and also, the injection of off balance sheet purchases. Take a look at the growth in the Fed’s balance sheet:

Keep in mind this is only based on depository institutions which are supposedly the safest of the safe. That puts us well over $600 billion in that quick jump you see above. If we throw in non-depository institutions the number jumps to over $2 trillion. Now take a look at the Fed funds rate. We are now back to 1%. All these actions at their heart are to get credit flowing into the system and get people to spend. The idea of course is to get people to spend but how are they going to spend money they do not have or have allocated to servicing current debts? The only bullet left in the chamber is for the U.S. government to start literally printing money. With the amount of debt we have, this is not a good idea.

So why haven’t these actions helped recently? Well, people are essentially maxed out. Let us take a look at total debt outstanding:



Americans are at the end of the rope with debt. With over $14 trillion in household debt outstanding, we now have as much household debt as our annual GDP! And keep in mind GDP is contracting so it may be the case by the end of the year that there is more debt than actual GDP. Deflation will do this because of the destruction of money. Let us now look at 5 areas that have been seeing deflation for a long time.

Area #1 – Housing

Nothing highlights the deflationary menace like declining home prices. In fact, it can be argued that every foreclosure that occurs is deflation in action. The lender no longer has the prospect of collecting the face value of the loan. Therefore, they have to writedown the loss. Which leads to even more cheaper homes on the market. It becomes a vicious feedback loop. As you can see from the Case-Shiller 10 composite, housing prices are clearly declining. There is heavy deflation occurring in this sector.

Home prices are now down 22% from their peak. That is a significant drop in prices. The issue that makes deflation more ominous is this. It creates hoarding behavior. After all, why would you buy a home today when chances are that in one year, it will be cheaper. It gives an incentive for people to save and not consume. That can be a problem when 71% of our economy depends on consumption.

Area #2 – Automobile Costs

This is probably the most significant story in the mainstream media at the moment. The prospect that the big 3 automakers are on the verge of bankruptcy. For the most part, much of their problems are self-initiated. They were riding high when gas was low and the demand for gigantic trucks and SUVs seemed to be insatiable. Well that bubble of course has also burst. Many times, you can find these cars now selling on Craigslist for insane prices. Take a look at this 2004 Escalade selling for $18,000:



This thing sold for nearly $40,000 brand new. That is deflation. There are many other cases like this on eBay as well. You can also look above at the CPI report and see that transportation costs for the last 3 months are running at a jaw dropping -28.9% compounded per year. That is simply incredible. This of course won’t continue forever but the big 3 automakers have saddled themselves with manufacturing equipment for vehicles that are dropping in price on a daily basis.

Area #3 – Fuel

Gas prices have fallen off a cliff. From a peak of $147 a barrel we are now hovering in the $50s only a few months later. This has sent a shock in many world markets like Russia that are heavily dependent on oil revenues. Some have tried to say this is a good thing and it is but not for the right reasons. It would be one thing if prices fell in good economic times. Prices have fallen because of demand destruction. Demand destruction from where? Americans are traveling less and buying more fuel efficient cars.

Gas is now half off in a few short months. This is another sign of deflationary forces. You can expect this to be passed on to prices at the grocery store. You will also see this in products at retail outlets. Retailers are already in a fury to cut prices to attract consumers. This will only feed that cycle again. Look at what occurred with Circuit City and Mervyns. Fuel dropping like this is simply another deflationary sign.

Area #4 – Wages

Wages have remained stagnant throughout this decade. The median income for an American household is $46,000. After taxes that is not much. Given the cost of homes in many metro areas that would eat up a major part of take home pay for any household. Add in the absurd prices of automobiles and you essentially have a small chunk left for food and utilities.

And one thing that is insanely deflationary for wages is unemployment. Unemployment is flying off the charts:

The rate now stands at a 14 year high and only shows more signs of increasing. The intense market volatility, which is not a sign of health, is only assuring us of more layoffs for at least for 1 or 2 years possibly more. There is nothing more deflationary than unemployment. In addition, many state governments have already frozen yearly pay increases and have already implemented hiring freezes and are laying workers off. Citi announced layoffs of 52,000 people this week. This is more signs of deflationary forces.

Area #5 – Commodities

Finally, commodities are dropping like a rock. Once thought to be a saving grace these areas are now collapsing. Take a look at oil. Gold has fallen from the peak above $1,000 to the current $740 an ounce price. Let us take a look at a few markets:

Taking a look at these markets, you wonder why in the world was anyone even worrying about inflation. It is true that many of these actions may in the far future lead to inflation but at the moment, there is one clear winner and that is deflation. We are clearly in a deflationary spiral much like the one that occurred during the Great Depression. That is why the stock markets now reached new lows and are all off nearly 50% in one year. That is a crash. No doubt about that. Yet the stock markets are only following in lockstep with housing, autos, fuel, commodities, and wages.

We are really in uncharted waters.

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