Deflationary Forces Strengthen

Lets take a look at prices today via the last week's CPI:



My Take:

Although I still believe that inflation is the longer term risk down the road, the threat of deflation in the near term is starting to rise substantially.

The drop in CPI in June versus a year ago was the largest drop in prices in more in 60 years!

Anecdotally, I was out at a nice prime steakhouse last evening and they told me they are dropping their prices nationally. Many other restaurants are doing the same. Go check out an Applebees or Outback and take a look at a menu and you will see the same thing: Lower prices and fewer patrons.

I am seeing signs of a crashing consumer everywhere.

Baltimore was eerily quiet last night. It was restaurant week which is a week here in the city where all the restaurants in Baltimore run huge dinner specials for 7 days.

Every restaurant is usually packed as a result. Not this week! Every place I went into was dead as a doornail last night. Usually on a Saturday during restaurant week you can barely get inside restaurants as people take advantage on the incredible deals.

Even thehe cabby's were telling me how dead its been. The city had a depressionary feel it it. It was pretty spooky.

I saw further examples of this at Best Buy yesterday when I was forced to go out and buy a computer after my Dell blew up yesterday morning. I went in thinking that a new desktop would run me $700 or so. I was shocked to see how much computer prices have dropped. I was able to buy an Acer with AMD's fastest chip, speakers, and a keyboard for $360! This was a pleasant surprise but shocking nonetheless.

Prices are dropping because companies are realizing that they need to adjust to this new world where the consumer is pretty much dead.

They will die themselves if they don't drop prices. This deflation can get really ugly because as companies drop prices, consumers tend to hold out thinking that prices will continue to drop.

This is called a negative feedback loop and it can devastate an economy because no one consumes anything thinking a bigger bargain is right around the corner. This is why the Fed is obsessed with trying to prevent deflation!

Here is an example of how a negative feedback loop can develop:

I was speaking to a mortgage analyst about the tax credit for first time home buyers. The housing industry is trying to raise the credit from $8000 up to $16,000. The 8k rebate ends on October 1st. The housing industry is trying to use the cash for clunkers success as a way to increase the rebate.

This sounds great in theory, but it can also backfire. Let me explain:

The first tax credit last year before this year's 8k rebate was $7500 but you had to pay it back at the rate of $500 a year until it was paid off.

As housing continued to suffer, the government decided to sweeten the deal for '09. They decided to make the tax credit $8000 that didn't need to be paid back at all.

Great news right? Well for most people that is: How do you think the people that got in on the first tax credit felt after seeing the second tax credit a year later that never needed to be paid back.

If the government once again attempts to raise the stakes and rolls out a $16,000 tax credit next year, how are the $8k'ers from this year gonna feel about that? Ummm..Let me answer that nicely. They will feel like they got totally screwed!

This stimulative effect is very effective in the beginning, however if you keep upping the ante, it can have the opposite effect because people will start to believe that they will get a better deal next year if they hold out.

Before you know it, a nasty feedback loop is created where consumers permanantly sit on the sidelines thinking that a better deal is right around the corner.

The Bottom Line:

I am starting to get concerned about deflation in the short term. What scares me even more is how the Fed will react if deflation begins to really take hold.

What might they do to fight it? They could start devaluing the dollar in an attempt to inflate out of it. This will not end well as prices will soar on everything which will further pressure the consumer.

Both inflation and deflation are a risk at this point. If deflation takes hold, shorting stocks and holding US dollars will be your best bets. Metals could take a beating in this scenario as prices drop on everything including commodities.

If the dollar begins to plunge once again, you need to be concerned about inflation. Once this deflationary period ends I still believe that inflation will be the long term problem because our Fed is acting so reckless when it comes to monetary policy.

That being said, the data for now is saying that the Fed is losing its battle with deflation. Hedging your metals positions by buying PUTS on metal ETF's might not be a bad play here.