Disinflation has been described as the slightly less ugly cousin of inflation. A more technical definition of disinflation can be found in Wikipedia.  They say “disinflation is a decrease in the rate of inflation.” This phase of the business cycle, in which retailers can no longer pass on higher prices to their customers, often occurs during a recession. Disinflation is lower inflation. Prices are still rising during disinflation, but at a lower rate. The general price level still rises, but, at a slower rate resulting in a continued, but lower rate of real value destruction in money and other monetary items. A lowering of inflation is not deflation but disinflation. In contrast, deflation occurs when prices are actually dropping. Deflation is negative inflation. Deflation means the general price level is not increasing at all, but actually decreasing continuously and the internal functional currency – money - and other monetary items are worth more all the time. Deflation causes an increase in the real value of money and other monetary items.”

The consensus view now is that inflation will soon run rampant, which will adversely affect the credit markets and push commodity prices higher. Our research suggests that just the opposite will occur, at least in the short run. Now there is even some talk of deflation. How ironic that just after a few short months later the fear now is that the continuing economic malaise in the U.S. may not merely just produce the tolerable disinflation, but it actually could be spawning a very much unwanted and damaging period of deflation. As commodity prices, from crude oil to base metals drop in value, the need for an extremely more accommodative Federal Reserve becomes more apparent. The myriad of stimulus packages, bailout plans and “bad bank” proposals, at least in the short run, will not be sufficient to offset the destruction of wealth that has taken place as a result of the subprime mortgage related write downs.

Although a minority view, there is some talk now that the U.S. could be facing the same disinflationary/deflationary pressures that plagued Japan’s economy several years earlier. It was only last July that the main worry that the Federal Reserve had was the threat of potentially uncontrollable inflation. As is usually the case, inflation usually becomes less of a concern when an economy starts to contract, which is the case now.



Current anemic economic conditions will likely foster a disinflationary environment, at least in the short run. December durable goods were down 2.5%, when a 2% decline was anticipated and durable goods, excluding transportation were down 3.6% against a guess of a decline of 2.7%. The 4Q annualized GDP was down 3.8%. This was the largest decline since 1982 and personal consumption was down 3.5%. The December personal income report showed a .2% decline and the November revision showed a .4% drop against a previously reported .2% decline. Personal spending was down 1%.

There was one bright spot. The index of pending home resales for December climbed 6.3 % to 87.7.  The median guess called for an unchanged figure from the November report. This was the first increase since August, from a revised figure 82.5 in November, according to the National Association of Realtors.  Pending resales are considered a leading indicator of the economy because they track contract signings. They have more predictive value than the existing home sales report, which are reported several months later. Countering this news to some degree were reports from other sources that showed there were a record number of vacant houses for sale in the last quarter as property values continue to decline.

It looks as though restrictive lending rules and further price declines will keep a many buyers out of the housing market. Underscoring this problem is a report from the Federal Reserve that said a majority of U.S. banks have made it more difficult for consumers and businesses to get credit in the last three months even though financial institutions received large injections of taxpayer funds. This report stated that about 65% of U.S. banks have reported tighter lending standards. It does appear rather ironic that U.S. banks have received over $200 billion of taxpayer funds and are actually making fewer loans. The U.S. Treasury promised that they will soon announce a plan that will encourage financial institutions to increase lending.

The President summed it up the best when he said the U.S. economy “is in for a tough several months” before a recovery takes hold. He also said “we will help lower mortgage costs and extend loans to small businesses so they can create jobs.” 



Even though the Federal Open Market Committee lowered interest rates by 75 to 100 basis points to a range of zero percent to 25 basis points at their December 16th meeting, it may not to be enough to quickly revive the U.S. economy. It now appears that more stimulus other than just zero short term interest rates is needed. There was talk as early as last December that, in order to keep long term interest rates low, some analysts were thinking that the Federal Reserve would soon start buying Treasury issues. This feeling was confirmed when the FOMC mentioned the possibility of buying Treasuries in their statement following their meeting on January 28th. Within their statement they said “The Federal Reserve continues to purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets and it stands ready to expand the quantity of such purchases and the duration of the purchase program as conditions warrant. The Committee also is prepared to purchase longer-term Treasury securities if evolving circumstances indicate that such transactions would be particularly effective in improving conditions in private credit markets.”



It will take time for all of the international governmental efforts to improve economic conditions. In the mean time global inflation rates are moderating as the international economy has yet to respond. Because of this disinflationary trend, economists are predicting that benchmark interest rates among the entire Group of Eight central banks will continue to be slashed on a wholesale basis. There is more talk that many of the major central banks may eventually drop their interest rates to near zero percent.

Because of declining inflation levels in the U.K. the Bank of England’s Monetary Policy Committee recently lowered their main interest rate by 50 basis points to 1%. Since late 2007 the U.K. central bank has lowered their key interest rate by 450 basis points. Current rates are the lowest since the Bank of England was formed in 1694. It is anticipated that economic reports to be released later this month in the U.K. will be weak and give the Bank of England further incentive to aggressively lower interest rates.

There are plenty of disinflationary forces at work in the euro zone as well. Europe’s manufacturing industry had declined for the eighth consecutive month in January.  The index of manufacturing activity was 34.4, which compares to the median guess of 34.5. In addition, the German Purchasing Managers Index dropped to 32, the lowest since the series was created, from 32.7 in the previous month. A recent report showed European producer price inflation slowed to the slowest rate in 16 months. This gives the European Central Bank more room to lower interest rates. Even though the European Central Bank left credit policies unchanged at their latest meeting on February 5th, ECB President Trichet said policy makers may reduce their benchmark interest rate by 50 basis points to a record low of 1.5% at their March meeting.  

It is not only G-8 countries that are aggressively lowering interest rates. This Monday the Reserve Bank of Australia cut their benchmark interest rate by 100 basis points from the previous level of 4.25%. Some analysts were anticipating a cut by as much as 125 basis points.    

Currently it appears as though the major central banks of the world cannot lower interest rates fast enough to offset the disinflationary and potentially deflationary impact of wealth lost as a result of the international economic crisis.   This influence will probably last for a good part of this year, at the least, before the expansionary impact of all the world’s interest rate cuts and stimulus packages take effect.  Make no mistake about it. Inflation is coming, but first there will likely be a period of falling commodity prices.  There should be ample opportunity to buy inflation hedges at lower levels closer to the middle of this year.    

If you would like more information about this article, please contact Alan Bush at 1.800.243.2649 or send an email to alan.bush@archerfinancials.com.

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