Sunday, August 16, 2009

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.


CT-Hilltopper said...
This comment has been removed by the author.
CT-Hilltopper said...

I wish I could edit my comments. Jeez!

Anyway, what I posted originally was that I couldn't agree with you more, Jeff (imagine that)!

I also had to get a new computer recently and was shocked at how cheap it was. Maxed out AMD, keyboard, and speakers for under $400 (also a desktop). I was expecting to pay much more. I paid cash for mine. The poor cashier looked like she didn't know what to do with cash. She also didn't know what to do when I told her that I wasn't "feeding the beast" by using my credit card to pay for purchases anymore.

I think she was glad to get rid of me. LOL

The silence here is also deafening, Jeff. This is the "Gold Coast", and we're in the middle of Back to School shopping season. People are not spending a dime that they don't have to. If they're not spending here...

Also, a lot more "For Sale" signs on homes than I've ever seen in my neighborhood. If I had to categorize this neighborhood I would call it middle class to upper middle class.

During the usual selling season, which I think of as spring, there were the McMansions on the market, and that was about it. Now about five other houses have joined them, and for this area, thats just not normal.

There is one house, down the street and around the corner from my house that has been on and off the market at least three times now. It's a beautiful house, someone gets interested in it, they go into closing and the sign is taken down, then within a week or so the sign goes back up and the Open Houses start over again. I can't help but to believe that in the end, something screws up with the financing every time.

Jeff, one thing to remember when it comes to the consumer. Almost 45% of the jobs created between 2000 and 2007 were connected to the real estate boom in some way. We needed more real estate agents, more appraisers, more landscapers, more maintenance workers, more house builders, more architects. more...well,, you come up with it, we needed more of it. These are jobs that are going away and aren't coming back, much like some of the tech related jobs did when the tech bubble busted. We're talking a lot of jobs here.

I don't think we're finished with high unemployment numbers just yet.

CT-Hilltopper said...

I have a question.

This is regarding the takeover of Wachovia by Wells Fargo.

I thought this was a done deal, but I still see Wachovia banks all over when I'm out driving. Usually when a bank is taken over by another, it's taken over. When WAMU was taken over by JPM, they took over everything, and didn't leave anything of WAMU behind, yet when Bank of America took over Merrill Lynch, Merrill Lynch was allowed to remain Merrill Lynch(although this may or may not be changing).

This is confusing.

So, why is Wachovia still Wachovia?

Jeff said...


Thanks for sharing the anedotes.

Regarding the Wachovia question my guess is its branding.

Merrill is a huge brand when it comes to wealth management so that one makes a lot of sense.

They have one of the strongest reputations for managing retirement portfolios.

Its a shame they didn't know how to manage their own portfolio. Ironic isn't it?

Herb said...

If the Fed increases the tax credit to $16k it will be very hard to wean the real estate industry off of this subsidy.

Deflation seems to be hit or miss these days. I was shopping last month and as I was looking at frozen pizzas a couple that I would not say were by any means economists or mathematicians remarked that Tontino's Party Pizzas were now $1.29 instead of the regular price of $.99. They quickly were able to determine that the price increase was 29% and did not buy any of them.

I did get a mailer with an ad from Outback advertising lower prices. That is the first time I have ever seen anything like that from Outback.

Jeff said...



Outback has a $9 steak I think now.

Its going to be interesting to see how this all plays out.

I see price increases in certian areas and price collpases in others.

Anonymous said...

If a deflationary spiral takes hold, as I have long predicted, we will be quite happy to see inflation on the backside of it. In fact, spring time inflation following a Kondratieff Winter season is deemed to be "beneficial."

The government is spending $250-billion a quarter trying to prevent a deflationary collapse. If they fail, the situation will be far uglier than if nothing had been done last fall to "rescue" the system.

jeff said...


The market is screaming deflation this morning.

ES is getting pummeled!

Hold onto your shorts. Today could be ugly.