Pretty much every week the mood shifts between people freaking out about inflation and people freaking out about deflation.
We’re inclined to chalking this up to a post-crisis era in which people can’t read any data without freaking out in some manner or another.
Thus we like this commentary from Deutsche Bank macro strategist Jim Reid on how the debate over the last two years has broken down.
Generally in my client meetings over the last 2 years of the recovery, one fierce debate that has run and run but has as yet seen no firm winner has been the inflation vs deflation battle. Investors with very similar views on this crisis can dramatically differ as to whether the endgame is inflation or deflation. If we arbitrarily break the 2-year recovery down in 4 equal length segments then its fair to say that during the first 6 months there were many who thought that it was in no way possible to generate any inflation for a number of years. Over the next 6 months the recovery helped those in the inflationary camp battle back especially when the scale of the Sovereign problems and how they are normally solved through history (monetisation) became apparent to a wider audience. Then came the Fed’s QE 2 which seemed to dramatically reduce the deflation concerns as did the spectacular rise of commodity prices in the following few months. However we’ve noticed that in the last few weeks there are a small but increasing number of people concerned again about deflation. This may be because QE2’s about to end, future fiscal flexibility is limited, US home prices continue to fall, money multipliers are still damaged, signs of softer data are emerging in spite of record stimulus, and due to the continued European woes. Last week’s fall in commodities has also convinced some that once commodity prices fall there will be no be inflation anywhere else.
For what its worth we think that if the authorities do nothing else in this crisis then deflation is still possible across the Developed World. However we find it inconceivable that they will sit back and no nothing and with Debt levels the size that they are, we still believe that if we don’t eventually have some inflation (ideally without the bond market reacting) then we will get a number of years where the risk of haircuts, restructurings and defaults across Sovereigns and Banks is high.