Tuesday, August 12, 2003

While the Fed and the financial markets don't want to think about deflation any more, the financial press hasn't given up on the story just yet.
Three months after the Fed began hinting about its readiness to nip any trend toward declining prices before it started, even if it meant reducing short-term interest rates almost to zero, officials have made it clear they are now less worried than they were before and more reluctant to jump in with unconventional tactics. . . .

Fed officials have made it clear they are less worried now about deflation than they were just a few months ago. Alan Greenspan, the Fed chairman, told a Congressional hearing last month that he did not think it would be necessary to fight deflation with unconventional tactics like buying up longer-term Treasury notes.
Yes, deflation is off most folks radar screen now, based on the completely faulty assumption that financial markets are fully rational and prescient. If stocks and interest rates are going up, that means the economy is heating up and thus prices will begin to rise again. Right?

The rosy scenario seems to rest on a few choice bits of data:
  • Rising business investment -- Indeed, nonresidential fixed investments rose 6.9% in real terms after falling nine of the last ten quarters. The big gainer in the category was computers and peripheral equipment, making up a whopping 65% of the gross rise in GDP for the entire quarter! Why such a huge rise? As Stephen Roach pointed out on Friday,
    it turns out that fully 83% of that gain is traceable to a collapse in IT pricing, according to Commerce Department assumptions. Indeed, in current dollars, last quarter�s growth in computers and peripheral equipment accounted for only 7.1% of the total gain in nominal GDP.
    Without that shot in the investment arm, nonresidential fixed investment growth would have been nonexistent. While everyone thinks they see rising business investment, they may be staring at a distant mirage.

  • Rising commodity prices -- The Journal of Commerce-ECRI Industrial Price Index, a measure of world commodity prices, is up 14.4% on an annual basis. Of course, in mid-May it was falling. Rising production not met by rising consumption is, of course, the classic deflationary formula. News out of China shows that industrial production is soaring again. This may be food for fighting Chinese deflation, but it may only exacerbate it in the US as corporate profits are squeezed and firms lay off more workers or at least refuse to hire any new ones.

  • Low short-term interest rates -- Cheap money, indeed. The one-year treasury bill is up from its mid-June low and now hovers around its February figures. What matters, of course, are real interest rates which have been negative since October 2001 (1-yr. T-bill minus core CPI). But as inflation abates, it becomes harder and harder to keep real interest rates negative. Core CPI-U in June ran at a 1.5% annual rate and core CPI-W at a 1.3% annual rate. Disinflation continues unabated. We'll see the July figures on Friday.

  • Tax cuts/rebates -- I'll let Citizens for Tax Justice fight this battle for me. The effects of the big Bush tax cut of 2001 are for the most part long gone -- see here and here. Moreover, one-third of Americans will get "a big fat zero" from the acceleration of some of those cuts and new ones on dividends for 2003 while "the median tax reduction is only $289". Maybe spending on Mercedes and marble shower stalls will revive the economy, but looking at how the dollar stores are leading the growth in retail sales in the US today, somehow I doubt it.


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