Deflation

Considering we are still in the throes of a recessionary environment, it isn't surprising that consumer prices are falling, or atleast, hardly rising. Outright deflation as seen in Japan is a scary phenomenon as it can exacerbate a recessionary downward spiral in prices. As an aside, you would think that given the steep drop in house prices, this is a no brainer. However, the calculation of CPI (consumer price index) uses owner's equivalent rent (essentially rent) which has fallen much slower than housing.

Ben Bernanke (the Fed chief, aka Helicopter Ben as you will figure out in a little bit) had make a comment many years earlier saying that the Fed always had a ready tool to fight deflation - dropping dollars out of a helicopter! While that is a picture worth remembering, the fed doesn't really own choppers. What they have done so far is to drop the overnight lending rate precipitously (some may say this is exactly what got us into this mess) and gone into the market and bought shitloads of RMBS (residential mortgage backed securities) and treasuries. The prior move (rates) is part of monetary policy but the latter (buying risky securities) is getting into the realm of fiscal policy, and is almost the equivalent of pumping $$'s into the system (for every dollar worth that the fed buys, there is an extra dollar in the capital markets that can be used elsewhere). This is in addition to all the stimulus provided by the government. All of this would make us believe that the total amount of dollars in the system would increase leading to inflation!

Undermining the effect of all of these moves is the massive deleveraging by the consumer and the tremendous decrease in the rate of bank lending. Although the fed can decrease effective interest rates, there needs to be end demand from consumers and businesses to increase their indebtedness as opposed to paying off or walking away from their present commitments. Additionally, there is massive overcapacity of production making it difficult for companies to raise prices. So all in all, there's a big tug-of-war going on with respect to prices.

I'll leave you with a graph showing the month-to-month change in the CPI. After plunging in '08, prices seem to have stabilized but there is still the fear that they will drop into negative territory in the coming months. Interestingly, the prior month (Jan '10) was the first in a quarter century when core CPI (excluding food and energy prices) dropped!!