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The Real Impact of Deflation

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Predictions for the US dollar, commodities, and gold: Up, down, and down.

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Editor's Note: The following was posted in real time on our premium Buzz & Banter (click for a free trial). It's being shared here for the benefit of the Minyanville community.


In the aggregate, prices in the US are falling. Overall consumer prices fell by 2.1% in the past 12 months according to the most recent CPI survey, the largest year-over-year decline since 1950. Core CPI, which excludes food and energy prices, is decelerating and currently stands at +1.5%. And if we take into account the massive price collapses in the housing sector and the stock market, it's clear that the US is experiencing overall price deflation.

Furthermore, consistent with the disinflationary momentum, the Michigan survey showed that expectations regarding future inflation continue to fall: 2.8% in August versus 2.9% in July. These expectations are down sharply from over 5% 12 months ago.

This is quite remarkable, given all the hoopla in the financial press about Fed "money printing" and potential hyperinflation. This datapoint regarding public perception is important, because myriad empirical studies have shown consistently that inflationary expectations are the most important predictor of actual inflation. Empirical studies have shown repeatedly that, without rising expectations, inflation simply won't rise, even with major increases in the money supply.

Note that the U of M data only reflects expectations of disinflation -- not deflation. However, after 60 years of inflation, it's hard for people to fathom deflation, so rapidly building expectations of disinflation may actually better correlate with the prospect of deflation from a predictive standpoint. There's some empirical support for this proposition in the data of the past 10 years.

In any event, disinflationary or deflationary momentum, combined with declining consumer expectations of inflation, is something to take very seriously. This can have a deep impact on consumer spending.

Here's why: Folks don't buy stuff today if they expect the price of stuff to fall tomorrow. They will postpone consumption as long as possible to take advantage of declining prices. This obviously puts a chill on consumption growth. This is precisely the opposite of what happens in an inflationary environment, in which people feel rushed to buy now before prices rise.

Therefore, possibly one of the most important potential indicators of consumer spending trends over the course of the next 12 months could be inflationary momentum, as reflected in the BLS data and consumer inflation expectations as reflected in surveys. I've therefore added these to the list of important indicators to monitor that I offered in Solving The Consumer Demand Dilemma.

As I argue there and in Retail Sales Are Warning Shot Across Economy's Bow, the trend in consumer spending is the single most important factor in the sustainability of the economic recovery in the US and of the current rally in equity prices. Predicting this trend should thus be the main focus of economic and financial-market forecasters. In this regard, I would point readers to Mish Shedlock's excellent article -- Consumer Price Index Primed for a Fall -- which reports on some very interesting consumer trends.

All of this logically also has implications for the US dollar, commodities, and gold. I am on the record clearly regarding my view of these 3 asset classes respectively: Up, down and down.

The way I am implementing this view is that I have various shorts or put positions on GLD, USO (through DTO), Freeport McMoran (FCX), Russia ETF (RSX), balanced against long positions such as Bank of America (BAC), Apple (AAPL) and Palm (PALM).

As I have stated on the Buzz & Banter, I won't press the aforementioned or other bearish positions unless the S&P 500 breaks down below 990. As we saw with yesterday's quadruple whammy of terribly disappointing retail sales, very disappointing Wal-Mart (WMT) report, very disappointing foreclosure data, and disappointing initial jobless claims -- all recovery killers -- the upside momentum in the equity market driven by high cash allocations and rising performance anxiety must be respected. Read my article Why Another Upside Move Cannot Be Ruled Out to understand why.

(Note: To readers that ask me about shadowstat's numbers: I give them no credence. At the other extreme, I don't think that the Case-Shiller Index should be incorporated into CPI, as Mish Shedlock suggests here (link to "What's The Real CPI" ).
Positions in AAPL, PALM, USO, DTO, BAC, RSX
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