Friday, June 27, 2003 11:30 am
"Deflation will feel a bit like living in Lewis Carroll’s world of 'Through the Looking Glass' – some things will appear to work backwards from what we are used to.”  I wrote those words in my column on November 7, 2002.  Since that time, the topic of deflation has moved from obscurity to become one of the top concerns for governments and central bankers.   

This week we had some strong evidence that we have passed through the looking glass, with things working backwards from what we are used to.  Was it related to the onset of deflation? Let's first look at the evidence.  

The first piece of evidence was the set of events precipitated by the Federal Reserve’s announcement at 2:15 EDT Wednesday that it would cut the federal funds rate by an additional 25 basis points.  The Fed’s purpose was to keep long and short term interest rates at their 40+ years lows, as part of the US government strategy to stimulate an economic recovery via a combination of easy credit, increased money supply, deficit spending, and a weak dollar. 

How did the markets respond?  At precisely 2:16 EDT, the US government bond market nose-dived.  At the time of this writing, interest on the 10 year and 30 year US treasuries have increased almost one half of one percent.  In the foreign exchange market, the dollar’s reaction was to strengthen against almost all currencies. Keep in mind that this was all caused by a move by the Fed to lower interest rates and weaken the dollar (although, for diplomatic reasons, it cannot admit to the latter).  Fortunately, I was short long-term treasuries, although I repeatedly questioned my own sanity as I awaited the Fed’s rate-cut announcement on Wednesday. 

The second piece of evidence came this week courtesy of the Bureau of Labor Statistics’ revised GDP report.  It turns out the BLS has been using a device called “hedonic adjustments” in an attempt to equate product performance improvements to price improvements. Here is OECD’s explanation under Real investment: deflation methods and adjustment for quality: “Some statistical agencies apply so-called ‘hedonic’ techniques to capture price changes in information and communication technologies goods. In the case of computers, the method consists in relating changes in computer prices to product characteristics such as memory, MIPS (million instructions per second) and processor speed. In the United States, hedonic deflation methods are used for most components of information and communication technologies investment. Other countries (e.g. Canada, Japan, France) are starting to introduce hedonic adjustment to measure real computer investment and sometimes base their deflators on the US ones.”  Here is how it works in practice: in the this week’s revised GDP report, the nominal spending on computers and peripherals was reported as $76.3 billion in the first quarter vs. $75.4 billion in the previous quarter, a gain of $900 million. But thanks to hedonic adjustments, the GDP total included this gain as $15.9 billion rather than the nominal $900 million.  Note that this additional $15 billion of “domestic production” was never actually transacted – no $15 billion cash actually flowed between anyone, and no $15 billion of additional products were actually manufactured, sold or bought in the quarter. 

The third piece of evidence was General Motors’ sale of $17 billion in bonds this week, the largest corporate bond sale in history.  One might be tempted to think: this is exactly what Alan Greenspan is trying to encourage – companies borrowing heavily to invest in expansion and growth.  So what does GM intend to do with the money raised?  It intends to use the proceeds exclusively to buy stocks and bonds through its pension plan.  That’s all.  No expansion, no new markets, no new product development.  Only a leveraged gamble on the future value of stocks and bonds. 

I wonder if this feeling of being on the other side of the looking glass means that we have already reached a deflationary state, I thought to myself as I cruised through eBay and ordered new computer equipment at 10 cents on the dollar.  Then I started to wonder how my eBay transaction will be reported in the next GDP report, after suitable hedonic adjustment …