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iTulip, Finster’s Comments
September 06, 2008, 02:22 PM

We are now two full months into deflation.

Most of us are now familar with the “strong dollar” story told by the forex-based “dollar index”. More often than not, however, that does not represent a truly strong dollar, but rather weakness in the other currencies against which the index compares the dollar. Measure a depreciating dollar in terms of other things that are depreciating faster, and – viola! – it looks like the dollar is going up.

This is not the case today, however. The FDI, which measures the dollar in absolute terms, shows the dollar to have been truly rising in value. This has some implications.

First, let’s note that the FDI is a recording instrument, not a forecasting tool per se. In other words, at face value it is not telling us whether we will have deflation next week, next month, or next year. It simply tells us we have had deflation since the beginning of July.

But it has been an exceptionally sharp and swift deflation. In just two months, the dollar has experienced a deflationary appreciation equivalent to the entire year or so from late 2000 to late 2001. Compare the rise at the far right of the above chart with that in the earlier time frame.

Second, it means that the same monetary policy that was too loose months ago is now too tight. The Federal Reserve should immediately reduce the fed funds rate by 50 bp to 1.50%.

Third, while it is not fundamentally a forecasting tool, the FDI does lead conventional measures of inflation. This is because those conventional measures act like long term moving averages; they introduce both a smoothing and a delay to what is actually happening to inflation. Unless the trend reverses powerfully and immediately, those conventional measures, including the CPI (including Williams’ SGS version) GDP deflator, etceteras, will moderate strongly over the coming months. It’s ironic that the same Fed that has been erroneously anticipating moderating inflation for over two years will finally, like a stopped clock, be right for once.

The original post, along with 1192 replies, can still be found at https://www.itulip.com/forums/forum/itulip-select/select-commentaries/finster-s-comments/5257-4-3-2-1-deflation?view=thread. Logging in can be a bit tricky but iTulip in general continues to be accessible. If you have your login info but are unable to log in, try going to the main site page at www.itulip.com and clicking “Login” in the upper right corner of the page. Navigate to “iTulip Select Premium Content”->Finster’s Comments”. On the default screen, the threads are unhelpfully arranged not by the stable date of creation but by the date of the last post, so despite its being one of the older threads in the forum you will find it listed among more recent material (on my screen Page 2). The chart that originally appeared was via pointer to a location now lost in cyberspace; this reprint contains my original copy.

The date of this post was nine days before the historic collapse of Lehman Bros, popularly blamed for the financial crisis. Among other things, this post shows that the conditions responsible for the crisis predated Lehman, and that in fact Lehman itself was a high profile casualty of a deflationary collapse that had began in the middle of the year.