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Inflation and Deflation

Why is Normal Inflation better than Deflation?


Deflation at extremes tends to be worse than inflation. Why? Interest rates can fall to zero and marginally below zero. As businesses and consumers feel less wealthy, they will consume and spend less. The lower consumption and spending lead to a further drop in demand. As prices decline, companies generate lower profits. When consumers expect prices to fall, they may delay their purchases. The lack of demand causes businesses to cut prices more leading to a downward spiral in prices. Prolonged deflation can lead to job losses, corporate and personal bankruptcies, and even foreclosures on houses. Rising inflation, at least in the US, is not as destructive as extreme deflation. However, it does impact the consumer and the investor. Rising inflation can lower your standard of living if your income does not keep pace with rising costs. It can also erode the value of your financial assets. The difference between deflation and inflation is that you do not lose your job, or companies do not go under unless there is severe inflation.


Fundamental Measures of Inflation and Deflation


The most common measure of inflation is the Consumer Price Index (CPI). CPI consists of a basket of goods such as consumer goods and services, health care, and transportation expenses. Economists and investment professionals typically follow this basket closely to understand the purchasing power of the US dollar. Others will also closely monitor interest rates, wages, unemployment, and commodity prices such as WTI Crude Oil, Copper prices, Gold, and industrial metals to gauge the economic conditions.


Technical Measures of Inflation and Deflation


Technically speaking, technical analysts also track interest rate rates and commodity prices to determine the sustainability of inflation and deflation trends. However, the simplest way to determine if inflation or deflation is developing is to follow the performances of a basket of inflation-sensitive stocks and a basket of deflation-sensitive stocks. By running a ratio analysis consisting of inflation-sensitive stocks and deflation-sensitive stocks, you can identify the inflection points when the economy shifts from one cycle to the next. After all, stocks are a leading indicator of US business cycles. Signs of persistent inflation or deflation will show up months and quarters in advance of pivotal economic turns.


Inflation and Deflation Index


Martin Pring, a famous Technician, developed the Pring Inflation index, which comprises mostly mining and energy stocks. These stocks tend to excel when the economy is strong and growing. The Pring Deflation index is a basket of deflation-sensitive stocks - namely financial companies, banks, insurance companies, and utilities. These stocks tend to excel when the economy is weak or during the early phases of an economic recovery.


Inflation/Deflation Indicator


Pring Inflation Index/Deflation Index is simply a ratio of the Pring Inflation Index divided by the Deflation Index. A rising ratio suggests rising inflation, and a declining one signals a deflationary environment. Historically, the indicator can lead the commodity market at both peaks and troughs.


A brief analysis of the inflation/deflation weekly indicator (0.24) shows a potential bottom has developed during 2019 and 2020 as evidenced by a higher-low pattern. The indicator established a pivotal low during Jan 2016 at 0.151 and a higher-low during 2019/2020 at 0.1609. A subsequent 4-year downtrend breakout (green dash arrow) further reaffirms a bottom. After achieving a bottom (Jan 2016), the inflation/deflation indicator quickly transitioned to a 5-year symmetrical triangle pattern as defined by 0.157-0.169 (bottom of triangle) and 0.290-0.309 (top of triangle).


The ability of the indicator to clear above 0.290-0.309 further reaffirms the start of rising inflation. Rising inflation is good for the economy if it is trending higher for the right reason. It hints of a sustainable economic recovery or an expanding economy. Also, note that since 2011, the dominant trend has been in a down-trending environment. The 38.2% retracement from 2011-2016 at 0.60 is well above its current level of 0.24, suggesting nominal inflation.


On the other hand, violation of the bottom of the triangle (0.157-0.169) confirms a technical breakdown and warns at the start of the next deflationary trend. Remember, a deflationary environment that spirals out of control is far more difficult for the Federal Reserve to control than a modestly rising inflation.


The daily chart of the inflation/deflation indicator (0.237) is nearing a near-term inflection, as evidenced by a sharply converging triangle pattern. A convincing move above key resistance at 0.2567-0.2595 (top of the triangle and the Jan 2021 high) confirms a technical breakout and signals the next rally to 0.2898 (May 2020 high). However, violation of 0.2281-0.2359 (bottom of the triangle and the Nov 2020/Feb 2021 low) confirms a technical breakdown and hints of a decline to 0.2044-0.2132. Despite widespread concerns about rising inflation, the daily inflation/deflation indicator has fallen over the past few months and is challenging the bottom of the triangle.


Conclusion


Based on the above weekly and daily analyses of the inflation/deflation indicator, inflation may very well develop in the future. However, it is too early to confirm rising inflation can lead to an extreme type of inflation such as hyperinflation. As mentioned before, a modestly rising inflationary trend is good for the economy and will allow for the continuation of a bullish stock market trend. An economy that is not too hot or too cold (goldilocks environment) will keep the Federal Reserve on the sidelines.


Source: Courtesy of StockCharts.com

Source: Courtesy of StockCharts.com

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