Posted by: Dirk | May 28, 2009

Inflation, Disinflation, Deflation and Oil

After the media consensus of yesterday to announce 0% inflation instead of deflation, most commentators argue that higher oil prices will make inflation increase in the next few months. Therefore, they argue, we have no problem with deflation. Let me elaborate on the assumptions of these arguments.

OPEC predicts oil to rise to $75-$80 a barrel by the end of the year. What are the assumptions of this expected price? It must assume a rise in global demand, which must come from a rise in economic activity. This rebound is essential for the today’s price of oil since it depends on future prices of oil. Why sell cheap now if you can get more in the near future? So even today’s oil price depends on the economic recovery – which is not real, but a guesstimate by economists which could not foresee the financial crisis, nor the depth, not the underlying problems, nor the transmission mechanisms.

My point is that if the forecasted economic recovery is not materializing, then deflation will be a major problem. No economic recovery, no oil price rise – and hence deflation. What makes me think that an economic recovery is not on its way? First of all, I don’t believe the market. I know stock markets are up, and that people there are optimistic. But they were optimistic some years ago and completely wrong. So, I want fundamentals.

Point 1: We have not reached the end of the financial trouble. Since accounting rules make it possible to postpone adjustments and allow banks to appear to be in better shape than they are, I see trouble ahead. Since the German Sparkassen have more possibilities to hide losses, I expect some nasty stuff showing up in there books later this year. Already, they declined to take over the Landesbanken, which they partly own.

Point 2: Industrial production is not coming up. The German Engineering Federation today published statistics according to which new orders in April 2009 are a whopping 58% less than last year. In other news, Opel, of General Motors Europe, is about to be restructured. Also, many companies are putting their workers on short time. At one point, they will figure out that laying off people will serve them better if the economy stays weak. All this will have consequences for demand.

I sincerely hope for an economic revival, but from what I see I would not be sure that it happens. Given the worst case scenario, I hope that politicians and economists are preparing a plan B. They had all the time to do so when the US went into the crisis, but failed to realize that it would hit them as well. Hopefully, they have learnt a lesson.

By the way: I like optimistic people, but there is a line. Wishful thinking – while bashing everybody else – and talking about “confidence” misses the point. Our GDP is built on hard work, not on financial tricks and fooling the public. The financial crisis has clearly shown that.

UPDATE 05/06/2009: James Hamilton says there is some speculation in the market which has driven the oil price up. Unwinding the extra oil reserves will drive the price down as soon as it is clear that the economy does not go back to growth. We have over-shooting today, and there almost certainly will be under-shooting tomorrow.

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