The Deflation Scenario

MarketWatch featured an interesting story titled “Is that deflation we smell?” Let’s listen in:

What do you call it when both stocks and commodities are plunging?

Can you say “deflation”?

To be sure, the monetary authorities, led by Fed Chairman Ben Bernanke, are doing everything in their power to keep this word out of our lexicon.

But trading sessions like Thursday are making it a lot harder for them to get away with it. Not only did the Dow Jones Industrial Average drop some 350 points, commodities also had a bad day: Gold fell by $5 an ounce, for example, and a barrel of crude oil fell by $1.50.

Nor was Thursday’s market action all that different than the pattern we’ve been seeing with increasingly regularity over the last couple of months. Oil is now more than $40 per barrel below where it stood in mid July, for example, and an ounce of gold bullion is now nearly $200 cheaper. Yet, far from providing the boost to equities that many otherwise expected, the stock market is essentially no higher today than it was then.

This is surprising because, other things being equal, lower commodity prices would reflect lowered inflationary expectations, which in turn would be good for equities.

But other things may not be equal now.

It would be one thing if inflation came down while the economy remained strong. In that event, the stock market would be shooting up right now–not plunging.

But inflationary expectations are receding today because of serious doubts about the health of the economy as a whole. And when the economy becomes weak enough, we should expect both stocks and hard assets to fall.

Unless Fed chairman Bernanke can pull more rabbits out of his hat, and soon, we should probably prepare ourselves for more days like Thursday.

I agree with that assessment, because it should not be earthshaking news to anyone that, with the continuing destruction of assets across corporate America, deflation has taken a firm hold. With the continuing unwinding of the credit bubble, the Fed is pretty helpless but to let the current scenario run its course. The question in my mind is just which entity will be big and important enough to get bailed out and which one with be not worthy of that option.

While I personally do not support any kind of bailout (because tax payers will be on the hook), choices will have to be made. Given the enormity of the credit crisis, even the Fed’s balance sheet has limits.

About Ulli Niemann

Ulli Niemann is the publisher of "The ETF Bully" and is a Registered Investment Advisor. Learn more
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