The Good, the Bad and the Ugly

Blondie: "If you shoot me, you won't see a cent of that money."
Angel Eyes: [frowning] "Why?"
Blondie:  "I'll tell you why." [He kicks the coffin lid open] "Cause there's nothin' in here!"
A scene from the movie The Good, the Bad and the Ugly released in 1966.

There is so much talk of deflation taking over the world that I thought it a good idea to explore the good, the bad and the ugly of the potential beast and to see just how precarious the situation has become.

First let's look at the good.  In certain cases deflation can help an economy particularly when the deflationary pressure comes from either technological advances or temporary pricing shocks.  With the oil price decline the relief that the consumer in the United States is feeling is a definite plus and akin to a tax break; it is putting much needed dollars into consumers' pockets and this is starting to have the effect of jollying along the economic recovery.  This is good deflation as it allows the Federal Reserve to let it run while reaping the benefits of accelerated economic growth.  In the case of the United States as the consumer makes up roughly 70% of the country's GDP more money in their pockets can really help.  Now the reason that this kind of deflation is good is because it is temporary.  The oil price relief will not last as even if the price remains low for an extended period the benefit will eventually be lost to other inflationary forces such as rising taxes, medical and insurance costs, food expenses and the like.  So while the immediate reaction is to fear for deflation, this kind of deflation is just what the United States needs right now.

Next is the bad kind of inflation and this brings me to the quote above.  Change the names of the characters from Blondie to Consumer and Angel Eyes to the Federal Reserve and you can see my point.  Should the Federal Reserve jump to the conclusion that deflation is here and it needs to be contained then they will raise rates prematurely.  This raising of rates will destroy any benefits received from the good deflation effectively killing the Consumer.  Once the Consumer is dead spending curtails and the result is that deflation then takes a firm grip.  Once it moves from temporary to longer term it has now become a problem and has now moved into bad category.

Finally the ugly part of deflation is that once it turns bad it can be next to impossible to extricate the economy out of its clutches.  In the case of Europe and Japan deflation there is ugly.  In Europe deflation has been caused by government austerity and requirements imposed by the EU.  By not allowing the rules to be bent in the face of adversity the very rules themselves have driven Europe to the brink of deflation without giving it the tools to extract itself.  More austerity means worse conditions and an acceleration into deflation's black hole.  As I showed last week yields on large swathes of European debt have already turned negative and even this is not helping.  Also as we have seen in Japan, once in a deflationary spiral it can take decades to extract oneself and even now, after trillions of Yen have been spent, the results are still miserable.  This is the ugly side to deflation, once it takes hold investment and spending shrivels while the mountain of debt remains intact eroding future investment and crimping the economy further.

The key right now is for the Federal Reserve to realize that it holds the global economy in the palm of its hand.  The only bright star in the global economy at present is the United States consumer who is benefiting from lower prices at the pump and low interest rates.  Raising interest rates too soon (as it is hinting) will kill the consumer pushing the entire world into the deflationary abyss.  My hope is that they are smarter than that and even though history has not shown them to make the wisest decisions I still fully expect rates to remain low for the rest of 2015.  Even Angel Eyes worked that one out!