Friday, October 29, 2010

“What Deflation?”

One of the Federal Reserve’s primary justifications for next week’s expected second dose of quantitative easing (QE2) is that inflation is actually too low in the current environment. In effect, they are worried about deflation setting in, which history shows can be difficult to break free from. The latest readings of the Core (ex- food & energy) Consumer Price Index have usually been used to back this assertion up, since they’ve been less than 1% for several months. Therefore, it was very interesting to see embedded in this morning’s initial release of third quarter GDP that the GDP price index, at 2.3%, was the highest it’s been since the third quarter of 2008 – just before the Great Recession began. Over the past four quarters, the price index has steadily marched higher from -0.2%, to 1.0%, to 1.9%, to 2.3%.

In recent weeks, one of the analysts who we read daily, Bill King of The King Report, has highlighted numerous examples of increasing price pressures, from individual companies raising prices, to soaring commodity prices, to certain foreign central banks actually raising interest rates. In his trademark colorful style, he has typically preceded each example with the rhetorical question “what deflation?” as he questions what it is that the Fed is actually trying to accomplish with QE2. He’s certainly not alone in being skeptical, as it seems that there’s been a growing chorus of opinion that the Fed is headed down a slippery slope that will undoubtedly result in significant unintended consequences as they dramatically expand their balance sheet for a second time. While the details and effectiveness of QE2 remain to be seen, the trend in the GDP price index (among other things) certainly challenges the notion that inflation is too low.

GDP Price Index