Monday, November 20, 2006

Goldie's Deflationary Growth

Is the unstoppable Goldilocks economy heralding a new period of deflationary growth?

Well, the Fed's tight money policy is squeezing nominal GDP growth to 3 percent or even less. Normally this would be a very negative sign for real GDP. However, bear in mind that the level of the October CPI, which fell 5/10th of one percent, is now 4.3 percent below the third quarter average for that index.

This could set up a negative inflation reading for the fourth quarter, something we haven't seen since 2001. So, even if nominal GDP growth in Q4 drops to 2 percent, a negative inflation reading could mean that real GDP will stay in positive territory. It could even be 2 percent to 3 percent after adjusting for a quarterly deflation.

Industrial and commodity indexes are still strong. This indicates that global growth is unimpaired. Meanwhile, the growth component of the 5-year bond, that is the five-year TIP yield, has gone up this year from 1.9 percent to around 2.5 percent. It's the inflation expectations component that has dropped from 270 basis points to 210 basis points.

So, actually, despite continued weakness in housing and soft reports for retail sales and industrial production, the real value of the economy should continue to rise, bolstered by a whiff of deflation.

Goldilocks lives. Deflationary growth. Lower oil prices. Lower interest rates. Rising economy.

That's my take.