Procerity

Evidence that deflation is becoming a problem is mounting. In the U.K. in October, the inflation rate dropped by 0.7% - the largest one-month drop ever recorded. Raw material costs in the U.K. plummeted at the highest rate in 22 years. The Bank of England is forecasting a contracting economy for most of 2009.

In Canada, the consumer price index experienced the largest one-month drop since June 1959. The annual inflation rate shrunk from 3.4% in September to 2.6%.

From September to October, U.S. inflation fell by the largest amount since record-keeping began in 1947, one full percent. And core inflation also fell by 0.1%, when economists had expected it to increase by that amount.

The apparent cause of looming deflation is a massive drop in global aggregate demand. Consumers have maxed out their credit and banks are hoarding cash - ingredients for prolonging a recession or even creating an economic depression. One extreme solution offered to counter the deflationary threat is to simply “print” money and deliver it directly to consumers to spend (sending out the helicopters to drop cash, as Milton Friedman is claimed to have said).

Of course this raises the spectre of rampant inflation. The situation is very delicate. Not enough “monetary easing”, and deflation threatens - too much “monetary easing” and excessive inflation is generated. With a relatively long duration between implementation and the impact of any action, the chance of erring on either side is quite high. Besides the risk of monetary easing being either too little or too much, there is the additional risk that its effectiveness will be limited because the population will remain skeptical (effectively shooting the helicopters of cash out of the sky).

Procerity’s Prognosis: Expect deflation to take hold in the near future followed by a period of overshooting inflation.