Evan Soltas
Jun 29, 2012

And Now, Deflation

The one-year implied breakeven on Treasury Inflation Protected Securities has fallen below zero, to -0.17 percent, signaling that the market expects headline CPI deflation over the coming year.

Looking at the data, which has turned sharply since this winter, it's easy to understand why. The CPI fell an annualized 3.4 percent in May, the steepest monthly drop since the crisis in 2008. On a year-over-year basis, headline inflation is plummeting, as every marginal month of deflation or extraordinarily low inflation pulls down the average, which was elevated because of price increases in the fall of 2011.The deflation is largely driven by falling fuel prices; that is, core inflation has stopped rising, but has not slowed. Given that the fuel component of CPI lags the price of Brent crude through retail gasoline prices, it is highly probable that CPI will continue to fall on the basis of catch-up fuel deflation alone -- that is, before even considering the significant likelihood that Brent crude continues to fall as global economic growth slows.A slowdown in food-price inflation in the, another component of headline CPI but not the core, also explains the deflation and is likely to continue, due to falling commodity prices and slowing global growth.

Here is the market forecast for CPI inflation for the coming five years. More than mere deflation, it is highly suggestive of a recession in 2013.
Incidentally, Intrade ascribes a 30 percent probability of recession in 2013.