Merrill's Rosenberg: Deflation is Here!

Good Afternoon Folks

A few comments before I go watch some college football! Here is Merrill Lynch's David Rosenberg's most recent update. Sorry, no link here folks. David's major concern is deflation next year. I am a big fan of this guy as you all well know.

Take a look:

"The CPI and deflation

Prices dropped in October. More to come.

Headline CPI dropped by 1% for October, the largest monthly decline in the 60-year history of the series, and core CPI declined by 0.1%, the first decline since 1982. We expect the November data to be even softer. The numbers suggest that businesses are trying to counter a massive drop-off in demand by cutting prices, and the price cuts they have taken so far are not doing the trick. With unemployment increasing, price competition will only intensify. That suggests that there is a genuine risk that the US economy could fall into a corrosive deflationary phase, one in which inflation turns negative while aggregate demand is weak.

CPI likely to deflate year-over-year in 2009

This is a trend in the making, in our judgment. Our models indicate that, by the second quarter of next year, there will be sequential declines in the CPI, and the index will be deflating on a year-on-year basis for the first time in five decades. The last time that occurred, the funds rate was 1% and the 10-year Treasury mote yield was hovering around 2-1/2%.

Interaction of aggregate supply & demand drives inflation

From a top-down perspective, what drives inflation are the shapes and the interaction of two different curves – the economy’s aggregate supply curve and the aggregate demand curve. The movements of these curves indicate where the “output gap” is at a particular time – the difference between the level at which the economy is actually operating and the level at which it would be operating if it were running flat-out at full employment.

In other words, the gap measures the degree of slack in the labor and product markets. According to our models, the output gap, currently at 2%, is right where it was the last time the Federal Reserve had cut the funds rate to 1% and when the yield on the 10-year note was hovering near 3.5%. That was during the summer of 2003. The difference, of course, is that back then the housing bull market was in full swing, the credit expansion was about to turn parabolic, and we were on the verge of a five-year upswing in profits, commodities, equity valuations,and the economy. In the year after the mid-2003 cut in the funds rate to 1%, real GDP expanded 5% and that output gap was sliced in half.

Output gap to widen to a never-before-seen level

Barring a further large dose of monetary easing and major fiscal stimulus, our models predict that the output gap is going to widen to 8% by the end of 2009. That’s a magnitude that we have not entered before. The extent to which the inevitable deflation will be sustained beyond 2010 is likely to hinge critically on the government’s ability to bolster aggregate demand growth. We sincerely wish the Fed and our fiscal policymakers good luck in dealing with this state of affairs. Deflation is a pernicious development insofar as it raises the real cost of debt and debt-service and, as a result, frustrates the private sector’s moves toward balance sheet improvement"

Bottom Line:

Mr. Rosenberg is basically telling you that he expects to see deflation at an unprecedented scale. Notice in the chart above, the last time we saw prices on assets drop anywhere near this far was in the early 80's when interest rates well over double digits as we fought the wicked inflation that haunted us in the 1970's.

The fact that this oncoming deflationary period is expected to surpass the early 80's deflation due to high interest rates is a frightening proposition. This basically tells me we are pretty screwed unless Obama pulls a rabbit out of his hat.

This does not bode well for housing prices or any other assets prices over the oncoming year. There is still no rush to go and buy a house right now folks! As you can see, Rosenberg expects a total freefall on assets in 2009 from a pricing perspective. Go read about Japan's deflation if you want to see how devastating hte effects of deflation can be. You can take a look at an old post of mine to see what it did to Japan's stock market.

A few reads:

A great commentary here from Bloomberg's Jonathan Weil. Why even get involved in this rigged game on Wall St?

3 more bank failures announced Friday

Until next time!

J