David Kelly: How likely is deflation?

The following is the weekly market commentary of David Kelly, the chief market strategist at JPMorgan Funds, for the week of August 16.

In the thick fog of our national pessimism, only the lowest-toned tales of impending doom find any resonance. So as summer winds down, fears of deflation are suddenly gaining wide attention. As scary stories go, this one has some qualifications. Deflation is both more serious in its consequences and more plausible as a scenario, than the inflation fears given wide circulation a year ago. But in the final analysis, how likely is it?

Last Friday’s CPI report gave us an update on the current balance of inflation pressures with consumer prices rising by 0.3% in July and by 1.3% over the past year. Core inflation, which excludes food and energy rose by 0.1% and was up by 1.0% year-over-year, the sixth straight month where year-over-year core inflation has been between 0.9% and 1.1%. Tuesday’s PPI report should also be mildly reassuring on the issue of imminent deflation.

As for inflation going forward, it is ultimately a statistical question. American inflation comes from two sources – the inflation we import through higher global commodity prices and a lower dollar and the inflation we generate internally through the interaction of supply and demand in labor markets, housing markets and our industrial sector. Numbers out last week and this week should provide some insight into both of these sources.

With regard to the former, last week’s trade report confirmed that the improvement seen in U.S. trade statistics between 2005 and 2009 has halted with the trade deficit rising for the fourth quarter in a row. This reality, combined with slow U.S. economic growth and an easy monetary policy, could push the dollar down over the next few years. Meanwhile, the Russian drought has boosted farm commodity prices and oil prices should rise in tandem with growth among developing nations.

As for domestic inflation, Tuesday’s Housing Starts report should show continued moribund housing activity. So far this year, multi-family housing starts have averaged less than a quarter of their average pace over the last 60 years. This virtual stall on supply should at least stabilize and eventually boost rents, an important component of core inflation. Similarly, with U.S. manufacturing capacity actually falling, the July report on Industrial Production should confirm that the manufacturing sector has now recovered half of the drop in capacity utilization seen in the recession.

The report on Unemployment Claims on Thursday is unlikely to show similar progress with regard to jobs. However, even with labor market weakness, provided we avoid a double-dip recession, the U.S. is unlikely to fall into outright deflation.
Avoiding that double-dip still seems probable, based on the already rock-bottom levels of economic activity in the economy’s most cyclical sectors. For long-term investors, this should mean that the fog of economic pessimism will eventually burn off, allowing both stock prices and Treasury bond yields to rise.

***** ***** *****

Tuesday, August 17th

Housing Starts Forecast Last
Starts, mils, ann rate 0.530 0.549
Permits, mils, ann rate 0.565 0.586

Producer Price Index Forecast Last
Overall, %ch 0.6% – 0.5%
Ex-Food and Energy, %ch 0.1% 0.1%

Industrial Production Forecast Last
Production, %ch 0.6% 0.1%
Capacity Utilization, % 74.6% 74.1%

Thursday, August 19th

Jobless Claims Forecast Last
Initial Claims, 000’s 465 484
Continued Claims, 000’s 4,425 4,452

Leading Economic Indicators Forecast Last
Index, %ch – 0.4% – 0.2%