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The housing starts data is more relevant for investors in U.S. equities, but the deflation commentary is important for all investors. Enjoy!

"AM Economics: Deflation is here, how long will it last? / Housing starts, bad is good

I'll admit it, I'm a sucker for economics. I always try to make sure that I am in my car on my way to work by 8:30 AM to catch the release of government statistics on CNBC. Two very interesting ones came out this morning CPI and housing starts. Surprise, surprise, both of them indicate that the economy is an absolute mess.

The CPI, aka consumer prices posted their steepest drop on record in October (see article: Consumer Prices Take Record Drop in October). The headline CPI number fell by a huge 1%, more than analysts expected and the largest drop since the government started keeping monthly data back in 1947. Even the much stickier core CPI, which excludes food and energy, dropped by 0.1%.

Clearly deflation is here. The question is how long will it last. In response to the economic slowdown, the government has slashed interest rates dramatically and it has been printing money at an alarming rate. These things are normally ultimately inflationary. Will they be this time or are we entering the beginning of an extended period of Japanese-like like deflation where interest rates near zero and government spending are unable to shake the deflation blues?

Given Bernanke's past speeches and papers on the subject of deflation, I suspect that the Federal Reserve will do everything within its power to prevent an extended period of deflation. I hope so. A positive, low rate inflation is healthy for economies. During periods of deflation people feel poorer as the value of their assets continue to decline. This anti-wealth effect, combined with the idea that consumers will delay making major purchases because they expect things to get even cheaper in the future are a recipe for economic disaster. Hopefully inflation, not hyper-inflation, or at least a stabilization of prices will occur at some point in 2009.

And now onto housing starts. Year-over-year, housing starts in October fell a staggering 38.0% (see article: Housing Starts Sank Again). Similarly, Building permits, a leading indicator, declined by 12% in October, much larger than the -3.1% that analysts were looking for. The decline in permits is actually accelerating, it was -6.1% in September.

While the drop in housing starts is clearly bad for home builders (I am short a ton of them in CAPS) and it is an indication that the economy is a mess, I actually welcome it. The United States already has an oversupply of houses on the market. Basic economics dictates that when there is a larger supply of something than there is demand for it, prices fall. Adding new homes to the current oversupply will just make things worse. Stop building new houses for goodness sake so that we can eventually work our way through this excess inventory.

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