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Deflation still a no-show




August inflation at the producer level came in at or slightly higher than expectations. So far this year, both headline and core producer price inflation are running at about a 2% annual rate. At the very least, this continues to rule out deflation, especially when we look at the price action at the crude level, where prices over the past year are up almost 20%.

Why then are so many observers—and the press—still obsessed with deflation? My guess is that the collective mindset is dominated by a faulty understanding of how inflation works. Even the Fed is guilty. It's very easy for people to believe that rising prices are the result of very strong demand, and that therefore weak demand should result in falling prices. We obviously have a very weak housing market, for example, and we observe that prices have indeed fallen significantly—by as much as 50% or so in the formerly high-flying Inland Empire market, and about one-third on average in major metropolitan areas, according to the Case-Shiller data. With everyone saying that the recovery is miserably weak, and with so many defaulting on their obligations and so many trying to deleverage, it is easy to extrapolate and say that demand is weak and therefore deflation is a real threat.

But the decline in housing and housing-related prices is not deflation, it's a relative price shift. It's the market's way of signaling that we have an excess of housing inventory, and the only way to clear that inventory is to lower prices. Lower prices send a signal to producers that we don't need new houses, so workers migrate out of the construction sector and into other sectors.

It's perfectly normal, even during times of inflation, to have some prices rise while other prices fall. Deflation is when all prices fall. That can happen only when the amount of money available in an economy is less than the amount desired—when money is effectively in short supply. If there's a shortage of money, then prices have to fall. If demand is weak and there is a shortage of money, then you have the ingredients for something nasty like a deflationary depression.

But that's not what we have today. There are a number of market-based indicators that tell us that money is not in short supply, and that money is in fact in abundant supply. If the dollar is weak relative to other currencies, it's because there is an abundant supply of dollars relative to other currencies. If gold and commodity prices are rising, it's because there is an abundant supply of dollars—lots of dollars chasing a limited outstanding stock of gold. A steep yield curve also reflects abundant money, because it is the market's way of saying that short-term interest rates are going to have to rise by a lot at some point in order to reverse the Fed's current willingness to over-supply dollars to the world. Very low swap spreads are another way that abundant dollars show up, because when money is easy to come by, then counterparty risk goes down.

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