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No signs of deflation in the dollar, gold, or commodities

The dollar is weak but improving on the margin, while gold prices and commodities are soft and declining on the margin, but still relatively high from an historical perspective. I think this points to a gradually improving outlook for the U.S. economy (e.g., double-dip inflation fears have now been replaced by a view that the economy can probably sustain modest growth of 2 or maybe 3%), and an ebbing of speculative pressures that had pushed gold and commodities to lofty levels. From a long-term perspective this is all positive. I don't see a reason to worry about deflation at this juncture.

The Fed's calculation of the dollar's inflation-adjusted value against a large basket of currencies and against major currencies is arguably the best measure of the dollar's effective strength vis a vis other currencies. As the chart above shows, as of the end of June the dollar was still quite weak from a long-term historical perspective, but it had risen on the margin in recent years.

Gold and commodities are in many ways the mirror image of the dollar's strength. Both reached very high levels from an historical perspective a few years ago, at the same time the dollar plunged to new all-time lows. Since then, gold has declined and commodity prices have eased, at the same time the dollar has recovered a bit.

The chart above shows the CRB Spot Commodity Index, arguably the best measure of non-energy, non-gold commodity prices, and its 5-year moving average (purple line). Although commodity prices are down from their 2011 highs, they are still above their 5-yr moving average. I show this on the theory that it takes perhaps 5 years for the world to adjust to commodity prices, so any important deviations from the 5-yr average creates problems, either for producers (unexpectedly weak prices) or consumers (unexpectedly strong prices). I note that the last time the U.S. came perilously close to a general deflation was in the late 1990s and early 2000s, and that happened to be a period during which commodity prices were exceptionally weak, both historically and relative to their 5-yr moving average. That's not the case today, so I think that argues against the risk of deflation.

As above chart shows, 5-yr TIPS and Treasury yields are priced to the expectation that inflation over the next 5 years will average about 2%. That is substantially higher than expected inflation was back in the late 1990s and early 2000s, and it is very close to the 2.1% average we have seen since TIPS were first introduced in 1997. In other words, there are no signs of deflation fears in the bond market.

The most likely explanation for what is happening to gold and commodity prices is that they are coming off of speculation-induced highs, not that they are now signaling deflation risk. An ebbing of speculative pressures such as these actually augurs well for the long-term outlook for the economy, since it means that investment decisions are increasingly based not on speculation, but on the economic merits of each decision.

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