September 16, 2008 / 11:54 AM / 9 years ago

Goodbye Lehman, Hello deflation: James Saft

6 Min Read

<p>People look out of the window at the Lehman Brothers Holdings Inc building in New York September 15, 2008.Joshua Lott</p>

-- James Saft is a Reuters columnist. The opinions expressed are his own --

By James Saft

LONDON (Reuters) - A few short weeks, a few banking failures, a massive fall in oil and commodity prices and deflation is back on the agenda.

The events of the weekend -- the failure of Lehman Brothers, the takeover of Merrill Lynch and insurance giant AIG's reported emergency appeal for Federal Reserve aid -- have given another kick to the vicious cycle of debts going bad and asset prices falling. More markers will be called, more assets marked down, more capital destroyed, less credit offered.

As for recapitalizing the banking system, sovereign wealth funds and anyone else with eyes and ears will be waiting on the sidelines for things to look slightly less grim.

Meanwhile, back in the real economy large swathes of the developed world from Tokyo to Berlin to Los Angeles have been hurt badly by the credit crunch and are very likely already in recession.

Oil and commodities prices are falling rapidly in response. Oil at about $95 a barrel is 35 percent below its summer peaks and the benchmark commodities index .CRB is down by more than 25 percent since July.

So even with inflation still at heady levels, the chances that we slip close enough towards deflation that it becomes a concern have increased markedly in recent days and weeks.

"Deflation looms, it certainly does loom," said George Magnus, senior economic advisor at UBS and a man who has predicted both the credit bust and many of its implications.

"The cycle in which debt destruction and asset price destruction reinforce each other clearly has a very, very strong negative effect on the economy. This effect is both direct and on banks, who are supposed to try and create the credit that makes economic growth possible."

Government bonds are certainly not showing a lot of worry about inflation, though this in part reflects a flight to safety as investors seek to hold the most secure instruments. Treasury futures had their biggest gain in 20 years on Monday and two-year yields dropped 40 basis points. A look at inflation protected bonds shows that market pricing in the least amount of inflation since 2003, when the Federal Reserve was last actively fretting about deflation.

A real estate bust and systemic banking crisis in Japan helped usher in a period of recession and deflation -- falling prices -- starting in the early 1990s. As production and consumption are delayed to take advantage of future lower prices, deflation can feed upon itself and be difficult to stop.

Japan resorted to extraordinary measures to halt the price drop, slashing interest rates to near zero and force feeding liquidity into the banking system. Inflation finally revived only with the help of the global commodity price boom.

What Inflation Threat?

It certainly looks as if the threat of inflation being exported from emerging markets has now diminished. China's central bank cut interest rates on Monday by 27 basis points and eased reserve requirements it places on banks, moves taken out of concern for deteriorating growth. Inflation in China has eased markedly in recent months; consumer prices actually contracted slightly during August.

To be clear, inflation in the United States still has a way to fall; consumer price inflation was 4.5 percent in July, the highest since 1991, and food prices may stay stubbornly high for some time to come.

So why will the demise of Lehman make price contraction more likely?

An enormous amount of leverage is being taken out of the system suddenly, prompting new sales of assets into a market already suffering indigestion. This will drive prices for many assets lower, which will in turn force other firms holding those assets on their own balance sheets to mark the value down. This creates even more need for new capital, and makes further failures of banks and insurers more likely.

Companies will find it tougher to get loans and will be more prone to throw people out of work.

The authorities have powerful weapons with which to fight deflation. They are already using one, having effectively nationalized the U.S. mortgage sector.

And there are also interest rate cuts. At this writing, the market was actually betting the Federal Reserve would cut rates when it decides on Tuesday.

Then there is the currency printing press. We are of course nowhere near that, and in some ways if inflation ebbs away the Federal Reserve will have a less complicated job than if they were trying to aid the recapitalization of a banking system with one hand and fight inflation with another.

Russell Jones, global head of fixed income research at Royal Bank of Canada in London, points out that CPI in the United States tends to fall by half or two-thirds following a recession and that its successive troughs have been lower and lower.

"At the very least the inflationary risk has diminished very sharply, at the most we could be moving to a problem of the opposite kind," he said.

-- At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund --

Editing by Ruth Pitchford

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