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There’s been a lot of good commentary in the last 24 hours regarding the deflationary impact of higher oil prices. Much of this discussion has been based around its impacts in Japan, however, it is applicable to the USA as well.  In a piece this morning FT Alphaville commentary from Macquarie and JP Morgan regarding this effect:

As Macquarie Securities noted:

“We disagree with the view that deflation means Japan is the one country to benefit from higher oil prices. In the previous commodity boom, profits peaked in 1Q07 and domestic demand in 2Q07 as higher commodity prices pushed the economy towards recession well before the Lehman’s collapse.”

Masamichi Adachi,  economist at JPMorgan in Tokyo, reinforced the point:

“Some commentators argue that the rise of commodity prices is welcome in Japan, which is suffering prolonged deflation. We disagree with this view. While the rise in food and energy prices may increase households’ inflation expectations, it does not mean that they can expect higher wages in the future. Actually, in a deflationary environment with considerable slack, the opposite will likely happen as the profit squeeze will weigh on wages, further restraining labor income and consumption. The deterioration in the terms of trade—resulting from a rise in import prices and a fall in (or flat) export prices—may be the drag on domestic demand, which is still sluggish and fragile.”

That’s right.  For a nation suffering a balance sheet recession the likelihood is that higher oil costs will serve only as a tax.  This supply shock results in depressing aggregate demand and furthering the likelihood of deflationary pressures.   Paul Krugman elaborated on this:

“So, does a rise in food and energy prices do anything to alleviate these (deflationary) problems? No. In fact, it makes them worse, by reducing purchasing power. So while the commodity surge may temporarily lead to rising headline prices in Japan, the underlying deflation problem won’t be affected at all.”

That’s exactly right.  At the end of the day rising oil prices will only crunch consumer balance sheets further which increases the likelihood of recession.  And for a nation with too much debt and not enough spending power that means producers will ultimately have trouble passing along any costs as end demand remains weak.  This might not lead to outright deflation, but it certainly won’t result in hyperinflation.

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