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Re: Deflation?



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From: Bill Bancroft <bbancroft@xxxxxxxxx>
Subject: Deflation?


>Is there a consensus on this forum regarding the US economy and
>deflation?
>Is our economy now deflationary vs. inflationary?
>Furthermore, if the economy is now deflationary, doesn't that change the
>relationship between stocks and bonds?
>

Just for the record, the numbers as calculated by the BEA say we are still
technically in a deflationary environment, which means prices are still
rising, but at a slower and slower rate (we're getting pretty close to
zero).  In order to be in a deflationary cycle, prices have to be actually
falling.  As others have already pointed out, it's important to remember
that this is an aggregate number.  The US economy is so diverse and complex
that certain parts can be inflating in price (health care) while others are
deflating (gasoline).

I think the US will stay in a range between disinflation and deflation for
many years to come.  The main reason we keep hearing that inflation is right
around the corner is because the unemployment rate is so low.   The problem
with this theory is that the evidence that low unemployment leads to
inflation is dubious at best.  The state of Nebraska now has an unemployment
rate below 2%, and yet there is no more inflation there than in the rest of
the country.  Labor costs may be rising, but that doesn't mean they will be
passed on to the consumer in the form of higher prices.  Companies are
offsetting higher labor costs with savings from enhanced productivity (many
people believe productivity gains are significantly understated in the
government numbers, and I agree).  The internet is also a massive
deflationary machine whose potential is only now being tapped.

>Here's why I ask:  Compare the recent action in the daily chart of the
>Dow Jones Industrial Average to the daily chart of the yield on the 30
>yr treasury bond.
>They look the same!  They both clearly show a bearish head-and-shoulders
>pattern that is close to breaking the neckline!
>


The long term relationship between stocks and bonds will never be broken,
because it's a simple case of opportunity cost.  As bonds rise in price
(interest rates fall), the return on those bonds begins to look less and
less attractive relative to stocks, so stock prices go up.  This comparison
/ trade-off will always exist, but in shorter time frames, other factors can
reign supreme.  For the past 18 months, that factor has been simple fear.  A
lot of foreign money has moved into US bonds- not because they thought the
bonds were undervalued relative to stocks, but because they were simply
looking for a safe haven for their money.  If bonds now start to rise, the
stock market is going to interpret this as a bearish sign because it would
signal that the global economic problems haven't bottomed out yet.  Once the
world economy "gets back to normal,"  so will the relationship between
stocks and bonds.  How long that will take is anybody's guess.

>Isn't this relationship consistent with a deflationary economy rather
>than an inflationary one?  Anyone familiar with Gibson's paradox?  "In a
>deflationary environment stock prices move inversely to bond prices."
>Are we there now?
>

There's nothing really paradoxical about it.  In thinking about the long
term relationship between stocks and bonds, it is important to remember one
thing.  When bonds are rising, you are assuming real interest rates are
falling, which for most of history is true.  However, there have been
extended periods when they weren't.  As Earl pointed out, a chart of the
1930's would have shown you that interest rates were falling, but so were
stocks.  The reason was that prices were also falling (deflation).   In
other words, even though NOMINAL interest rates were falling, REAL interest
rates were rising, which is bearish for stocks (as the long term
relationship tells us).

It's interesting to note that even though Greenspan has cut NOMINAL short
term rates three times since last summer, REAL short term rates are  only
fractionally lower now than they were a year ago...  In fact,  the free
market (through the yield curve) is telling Greenspan that (nominal) short
term rates are still too high.

Bruce