Monday, January 19, 2009

Deflation ... Or The Effect of a Commodity Bear Market?

There has been increased talk of deflation over the last few weeks. What people are concerned about is a deflationary spiral:

A deflationary spiral is a situation where decreases in price lead to lower production, which in turn leads to lower wages and demand, which leads to further decreases in price. Since reductions in general price level are called deflation, a deflationary spiral is when reductions in price lead to a vicious circle, where a problem exacerbates its own cause. The Great Depression was regarded as a deflationary spiral.

However, I'm not sure this is an issue. From a look at the following charts, it looks as though we're feeling the effect of a commodity price bubble popping.

First, consider these three charts:

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While industrial metals probably weren't in a bubble, prices have collapsed over the last six months. Given the major drop in industrial production this is to be expected.

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There is a higher possibility agricultural prices were in a price bubble of sorts. They formed a double top in 2008 and have since fallen approximately 50% since their second top at the end of the second quarter 2008.

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The CRB index is heavily influenced by oil, which hit the 140+ level at the end of last summer. Now this index has also dropped about 50%.

So, two groups of commodities (agriculture and energy) were at really high prices. Some would argue these commodities were in a price bubble. I'm not sure if that was true or not -- there were strong reasons for a fundamental bull market. However, the rapid descent of the respective prices does give strong ammunition to the people who argue there was a bubble.

That being said... consider these charts.

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Above is a chart of the year over year change in CPI for all goods. Notice we are approaching the 0% level. That is something we haven't done for over 50 years. This is one of the primary problems of the Great Depression -- a deflationary spiral. Now prices are moving into that direction which has everybody understandably concerned.

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However, notice that the year over year rate of change for core CPI is still high. This tells us that the deflationary problems are commodity based. As does this chart of CPI's energy component

But note that food prices are still increasing year over year. In other words, from a CPI perspective, the drop in energy prices is a big reason for the big overall year over year drop.

Let's go a bit farther back in the product life cycle:

Above is the PPI for all commodities. Notice this has taken a nose dive. But:

Core producer prices prices still have a healthy year over year price gain. That's because

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Producer prices for all commodities are dropping like a stone.

In other words, assuming the commodity prices were in a trading bubble, does that mean this isn't really deflation but instead a commodity based correction?