The Fed is worried about one form of deflation: price drops for good and services. If so many other kinds of deflation are already present, can goods and services deflation be far behind?
When the Federal Reserve announced "Operation Twist" in September, buying long-term securities in order to lower long-term interest rates, it sent an important signal: It's worried about deflation again.
Deflation to the Fed means substantial and chronic price drops for goods and services that risk creating a self-perpetuating downward price spiral. If buyers think prices will be lower in the future, they delay purchases, creating more economic decline, which pushes prices lower, and so on.
This is one form of deflation, but there are six others (see my latest book: "The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation"). Five forms are already in place in the United States. There's deflation of:
1. Financial assets. It started with the 2007 collapse in subprime residential mortgages, which touched off the swoon in stocks and bonds. Massive monetary and fiscal stimuli revived them starting in early 2009, but financial assets are sinking again under the weight of an increasingly recession-prone US economy, a likely hard landing in China, and Europe's sovereign-debt crisis. That crisis and ratings downgrades are forcing down the value of sovereign debt and bank shares.
2. Tangible assets. The 20-city house price index from S&P/Case-Shiller is down an average 4.2 percent from a year ago and 32 percent from its April 2006 peak. Moody's/REAL Commercial Property Price Index has dropped 43 percent from its October 2007 peak.
3. Commodity prices. The trend started earlier this year. Copper, which measures global industrial activity since it's used in almost all manufactured products, is down 28 percent from its peak in February. Cotton's off 53 percent since March. Even gold is down 12 percent from its early September peak after a meteoric rise. The hard landing I foresee for China will erode, probably destroy, the basis for the global commodity bubble – namely, the conviction that China will continue to buy all the industrial and agricultural commodities in sight.