This week, a slew of economic data has confirmed what many expected: Shrinking economies have combined with tumbling oil prices to raise the specter of deflation across the industrialized world.

A quick review of the pertinent events: The BOE monetary-policy committee voted unanimously to cut rates 1.5% after the consumer price inflation rate basically entered free-fall, dropping .7% in one month. It was announced Japan’s economy has been receding the past two quarters. US housing starts fell to their lowest level in about fifty years. More importantly, consumer prices plummeted 1% in just one month. Citigroup’s goose is apparently cooked, requiring another bailout. Finally, chances of a bailout of Detroit appeared to slide, as Congress decided to play pretend-economics and lose far more than $25 billion in tax receipts and unemployment benefits instead of on a loan that would ultimately be repaid.

In short, this week brought about some very, very, very bleak news. And that has created real fears of sustained deflation.

Importantly, the creation of those fears was immediately preceded by a massive build up in government debt.

Right now, most governments would prefer inflation to be around 6-7%, spurring a little private investment and at the same time dropping the cost of their debt.

Instead, we are facing the possibility of negative rates of inflation for at least the next quarter.

What all of this means is that you should erase any skepticism that the next round of government stimulus will be huge. Private demand for debt is nose-diving, and each dollar governments spend stimulating the economy right now will be heavily discounted by the upward pressure it puts on inflation right now – and it will take a lot of spending to bring inflation back up to where it should be.

One interesting factor here: That logic doesn’t apply as fully to EU governments, who not only won’t get the same inflationary benefit to their spending due to their multi-national currency, but also face notable debt ceilings that the ECB will, to some extent, use as leverage (no pun intended) to keep governments from spending too much.

The US and the UK, however, are different stories. On top of the BOE’s massive rate cut, the BOE signaled future cuts to be all but inevitable. Look for fiscal policy in the UK to take the same policy: the no-one-cares-about-inflation-because-we’re-all-gonna-lose-our-jobs-if-we-don’t-keep-this-recession-from-getting-too-deep policy.

In the United States, the President-Elect signaled today in his weekly You Tube address that the stimulus will be on the larger side of things. Starting his message off by rattling off some of the week’s terrible news, he noted the risk of deflation and then devoted the rest of the message to an argument for a large stimulus package, “a two year, nation-wide effort to jump-start job creation in America.”

Much of the makeup of the bill seems to be focused on his campaign promises to rebuild infrastructure and jump-start a domestic green energy industry.

It’s not a coincidence the President-Elect’s announcement focuses on the gravity of his stimulus package one day after he rallied the markets by announcing Giethner will be his Treasury Secretary. It’s part of a coordinated plan to reassure markets that aggressive action will be taken as soon as a functional government comes into office.

What does it all mean for the forex market? A column written on this page last week expressed skepticism that the stimulus will be large enough to meet the challenges ahead and thus give a boost to the dollar. This week’s events, however, have made it more likely that the stimulus will be larger than the $300 billion number being thrown around by analysts at Goldman Sachs and other companies.

It would still be surprising if it were to exceed $500 billion, but after this week, it is a much safer bet that the announcement of the details of the stimulus package will lead to a notable and immediate uptick in the value of the US dollar.

This entry was posted on Saturday, November 22nd, 2008 at 4:39 pm and is filed under British Pound, Euro, US Dollar. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.