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October 30, 2008

The Looming Deflation/Reflation Whipsaw

Economists and pundits are spinning their heads in circles, going from inflation worries a few months ago, to deflation worries today, but still fretting about inflation in the future. It’s highly amusing to watch, and points to the perils of static equilibrium models of the economy. They make it hard to deal with the real world.

The issue isn’t one or the other, of course: It’s both. We are going to have material deflation over the next twenty-four months, likely as much as 3% a year, and then we are going to have an inflationary snapback immediately afterwards.

Rates will get to nearly zero, and then they will go whipsawing in the other direction within 36 months. That will neatly choke off tepid economic growth while fighting commodity-driven inflation, sucking us back into a double-dip recession around 2011/12. The trouble is, while the Fed will want to cut rates at the time, it will have far less room to move given the its capital needs, so we will have the first high-rate recession –- stagflation –- in thirty years.

Rinse and repeat.

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