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Today, following a US hard landing and a global economic slowdown, the risks of outright deflation would be lower than in the 2001-2003 episode because of various factors: US inflation starts higher than in 2001; the Fed needs to worry about a disorderly fall of the US dollar that may increase inflationary pressures; the rise and persistence of growth rates in Chindia and other emerging market economies implies that – even if such economies likely recouple to the US hard landing – a global growth slowdown will not turn into an outright global recession that would be truly deflationary. Still, while the scenario outlined here – US recession and global slowdown – may not lead to outright deflationary pressures it would certainly lead to a slowdown of US and global inflation.

The fact that the most likely scenario in the global economy in 2008 is one of a negative global demand shock is the one that is priced by bond markets: if investors were really worried about a rise in US and global inflation – or about true stagflationary shocks – the yield on long term government bonds would have not fallen as sharply as it has since last summer. With US 10 year Treasury yield now well below 4% and sharply falling in the last few weeks it is hard to see a bond market that is worried about global inflation or global stagflation. And while until recently commodity prices pointed to the other directions, recent weakness in oil prices, the cost of shipping commodities and the price of some other commodities also signals that commodity markets are now pricing the risk of a US recession and the risk that – with a lag – a US recession will lead to a broader global economic slowdown.

So in conclusion “stag-deflation” (i.e. low growth or recession with falling inflation rates and possible deflationary pressures) is more likely than “stagflation” (low growth or recession with rising inflation rates) if a US hard landing materializes and leads – as likely – to a slowdown in global demand and growth.

So last January I argued that four major forces would lead to a risk of deflation (or stag-deflation where a recession would be associated with deflationary forces) rather than the inflation risk that at that time – and for most of 2008 – mainstream analysts worried about: slack in goods markets, re-coupling of the rest of the world with the US recession, slack in labor markets, and a sharp fall in commodity price following such US and global contraction would reduce inflationary forces and lead to deflationary forces in the global economy.

How have such predictions fared over time? And will the US and global economy soon face sharp deflationary pressures? The answer deflation and stag-deflation will in six months become the main concern of policy authorities. Let me now explain in more detail why…

First, what has happened in the last few months? The US has entered a severe recession that is already leading to deflationary forces in sectors where supply vastly exceeds demand (housing, consumer durables, motor vehicles, etc.) while now aggregate demand is sharply falling below aggregate supply; the unemployment rate is sharply up while employment has been falling for 10 months in a row; and commodity prices are sharply down – about 30% from their July peak - in the last three months and likely to fall much more in the next few months as the advanced economies recession is becoming global. So both in the US and in other advanced economies we are clearly headed towards a collapse of headline and core inflation.

Is there any doubt about this ongoing inflation capitulation and the beginning of sharp deflationary forces? Take the current views of the economic research group at JP Morgan; this group was in 2007-2008 the leading voice arguing about the risks of rising global inflation, about the associated risks of a global growth reflation and arguing that policy rates would be sharply increased in 2008-2009.

This week instead this JP Morgan research group published its latest global economic outlook arguing that we are headed towards a global recession, negative global inflation and sharply lower policy rates in the US and advanced economies (a 180 degree turn from its previous position). As written in the most recent JP Morgan Global Data Watch:

“A bad week in hell

Increasingly, the signs point to a deep and synchronized global recession. Today’s reported slide in UK 3Q08 GDP is expected to be followed by contractions in the United States (next week), the Euro area, and Japan—confirming that the global downturn began last quarter. More troubling is the additional loss of momentum at quarter end, combined with collapsing October survey readings. These developments appear to be part of a negative loop in which economic and financial weakness are feeding on each other, making the prospects for growth in the coming months decidedly grim. Once again we have taken an axe to near-term growth forecasts for the developed world and will likely follow up with additional downward revisions for emerging market economies in the coming weeks. Already, our forecasts suggest that global GDP will contract at a near 1% annual rate in 4Q08 and 1Q09.

It is still too early to accurately gauge the depth of the downturn, as the outlook depends on how well policy actions contain the financial crisis. From a US perspective, our current forecasts place the contraction in GDP somewhere between the last two mild recessions and the deep contractions of 1973-75 and 1981-82. This picture masks the degree to which the pain of the current downturn is falling on households. From the perspective of wealth losses and declines in real consumption, the current recession is likely to prove more severe than any of the previous ten in the post World War II era (see Special report: How deep is the ocean? Gauging US recession contours). For Western Europe, the current downturn is currently projected to look similar to the one in the early 1990s—the last episode in which regional GDP contracted…

Inflation and real policy rates to go negative

With part of this year’s slide in global growth linked to an inflation shock, the recent collapse in global commodity prices should be seen as an important factor cushioning the downturn. In the six months through August 2008, global consumer prices rose at a 5.6% annual rate, prompting stagnation in real consumption across the globe. Based on recent moves in the price of oil and other commodities, it is likely that the coming six months will see headline inflation dip below zero. While this swing will be a plus for consumers across the globe, it is also a development that will promote a significant growth rotation towards the G3 and Emerging Asian economies that were hurt most severely by this negative shock. In the developed world, this backdrop of contracting GDP, collapsing inflation, and financial market stress opens the door to a powerful monetary policy response.

So the leading supporters of the view that the global economy risked rising inflation, rising growth reflation and sharply higher policy rates to fight this inflation are now predicting a global recession, global deflation and sharply falling policy rates. What a difference a year makes!

Any further doubt that we are headed towards a global deflation or – better – a global stag-deflation? Aggregate demand is now collapsing in the US and advanced economies and sharply decelerating in emerging markets; there is a huge excess capacity for the production of manufactured goods in the global economy as the massive and excessive capex spending in China and Asia (Chinese real investment is now close to 50% of GDP) has created an excess supply of goods that will remain unsold as global aggregate demand falls; commodity prices are in free fall with oil prices alone down over 50% from their July peak (and the Baltic Freight Index - the best measure of international shipping costs - is 90% from its peak in May); while labor market slack is sharply growing in the US and rising in Europe and other advanced economies.

And what are financial markets telling us about the risks of stag-deflation?

First, yields on 10 year Treasury bonds fell by about 50bps since October 14th getting close to their previous 2008 lows; also two-year Treasury yield have fallen by about l50bps in the last month. Second, gold prices – a typical hedge against rising global inflation – are now sharply falling. Finally, and more importantly, yields on TIPS (Treasury Inflation-Protected Securities) due in five years or less have now become higher than yields on conventional Treasuries of similar maturity. The difference between yields on five-year Treasuries and five-year TIPS, known as the breakeven rate, fell to minus 0.43 percentage points; this is a record. Since the difference between the conventional Treasuries and TIPS is a proxy for expected inflation the TIPS market is now signaling that investors expect inflation to be negative over the next five years as a severe recession is ahead of us.

So goods markets, labor markets, commodity markets, financial markets and bond markets are all sending the same message: stagnation/recession and deflation (or stag-deflation) is ahead of us in the US and global economy.

So, don’t be surprised if six months from now the Fed and other central banks in advanced economies will start to worry – as they did in 2002-03 after the 2001 recession – about deflation rather than inflation. In those years where the US experienced a deflation scare Bernanke wrote several pieces explaining how the US could resort to very unorthodox policy actions to prevent a deflation and a liquidity trap like the one experienced by Japan in the 1990s. Those writings may have to be soon carefully read and studied again as the US and global economy faces its worst recession in decades and as deflationary forces envelop the US and other advanced economies.

Finally, while in the short run a global recession will be associated with deflationary forces shouldn’t we worry about rising inflation in the middle run? This argument that the financial crisis will eventually lead to inflation is based on the view that governments will be tempted to monetize the fiscal costs of bailing out the financial system and that this sharp growth in the monetary base will eventually cause high inflation. In a variant of the same argument some argue that – as the US and other economies face debt deflation – it would make sense to reduce the debt burden of borrowers (households and now governments taking on their balance sheet the losses of the private sector) by wiping out the real value of such nominal debt with inflation.

So should we worry that this financial crisis and its fiscal costs will eventually lead to higher inflation? The answer to this complex question is: likely not.

First of all, the massive injection of liquidity in the financial system – literally trillions of dollars in the last few months – is not inflationary as it accommodating the demand for liquidity that the current financial crisis and investors’ panic has triggered. Thus, once the panic recede and this excess demand for liquidity shrink central banks can and will mop up all this excess liquidity that was created in the short run to satisfy the demand for liquidity and prevent a spike in interest rates.

Second, the fiscal costs of bailing out financial institutions would eventually lead to inflation if the increased budget deficits associated with this bailout were to be monetized as opposed to being financed with a larger stock of public debt. As long as such deficits are financed with debt – rather than by running the printing presses – such fiscal costs will not be inflationary as taxes will have to be increased over the next few decades and/or government spending reduced to service this large increase in the stock of public debt.

Third, wouldn’t central banks be tempted to monetize these fiscal costs - rather than allow a mushrooming of public debt – and thus wipe out with inflation these fiscal costs of bailing out lenders/investors and borrowers? Not likely in my view: even a relatively dovish Bernanke Fed cannot afford to let the inflation expectations genie out of the bottle via a monetization of the fiscal bailout costs; it cannot afford/be tempted to do that because if the inflation genie gets out of the bottle (with inflation rising from the low single digits to the high single digits or even into the double digits) the rise in inflation expectations will eventually force a nasty and severely recessionary Volcker-style monetary policy tightening to bring back the inflation expectation genie into the bottle. And such Volcker-style disinflation would cause an ugly recession. Indeed, central banks have spent the last 20 years trying to establish and maintain their low inflation credibility; thus destroying such credibility as a way to reduce the direct costs of the fiscal bailout would be highly corrosive and destructive of the inflation credibility that they have worked so hard to achieve and maintain.

Fourth, inflation can reduce the real value of debts as long as it is unexpected and as long as debt is in the form of long-term nominal fixed rate liabilities. The trouble is that an attempt to increase inflation would not be unexpected and thus investors would write debt contracts to hedge themselves against such a risk if monetization of the fiscal deficits does occur. Also, in the US economy a lot of debts – of the government, of the banks, of the households – are not long term nominal fixed rate liabilities. They are rather shorter term, variable rates debts. Thus, a rise in inflation in an attempt to wipe out debt liabilities would lead to a rapid re-pricing of such shorter term, variable rate debt. And thus expected inflation would not succeed in reducing the part of the debts that are now of the long term nominal fixed rate form. I.e. you can fool all of the people some of the time (unexpected inflation) and some of the people all of the time (those with long term nominal fixed rate claims) but you cannot fool all of the people all of the time. Thus, trying to inflict a capital levy on creditors and trying to provide a debt relief to debtors may not work as a lot of short term or variable rate debt will rapidly reprice to reflect the higher expected inflation.

In conclusion, a sharp slack in goods, labor and commodity markets will lead to global deflationary trends over the next year. And the fiscal costs of bailing out borrowers and/or lenders/investors will not be inflationary as central banks will not be willing to incur the high costs of very high inflation as a way to reduce the real value of debt burdens of governments and distressed borrowers. The costs of rising expected and actual inflation will be much higher than the benefits of using the inflation/seignorage tax to pay for the fiscal costs of cleaning up the mess that this most severe financial crisis has created. As long – as likely – as these fiscal costs are financed with public debt rather than with a monetization of these deficits inflation will not be a problem either in the short run or over the medium run.