...On the interest rate front, yields declined late in the week, but more striking is that fact that the "real" yield on TIPS (Treasury inflation protected securities) fell faster. In other words, interest rates did not decline because of downward pressure on expected inflation, but because of downward pressure on real interest rates.
This is crucial, because market action is saying something different from the common "deflation ahead" scenario. Real interest rates measure the tradeoff not between dollars today and dollars tomorrow, but between real goods today and real goods tomorrow. International evidence is very clear that higher real interest rates are associated with higher rates of economic growth, because they signify that real goods are scarce today, relative to the future (i.e. goods will be more plentiful thanks to anticipated economic growth, therefore borrowers must promise many goods tomorrow in order to borrow real purchasing power today). In contrast, when real interest rates are declining, as they are now, it is a signal that real goods are relatively plentiful today, in comparison to the future. That is, economic growth is likely to stagnate.
(Geeky theoretical note: One might think that lower real rates would lead to higher investment, but this is a demand-side-only analysis, not an equilibrium one. If the supply of loanable savings is not shifting out, the observation of falling real rates in equilibrium is an indication that the entire demand schedule for real investment is shifting back. This observation is independent of the fact that the demand schedule is itself negatively sloped. The positive relationship between real interest rates and economic growth is fully consistent with standard equilibrium growth theory. In an intertemporal equilibrium, the growth rate of consumption is an increasing function of the real interest rate. Therefore, a lower real interest rate implies slower growth in consumption, other things being equal, largely due to an emphasis on current consumption over real savings and investment. This is precisely what we observe in the U.S. economy).
Notice that a decline in economic growth need not be associated with deflation. Indeed, the data are clear that there is an inverse relationship between economic growth and inflation. The lowest inflation rates are typically associated with periods of fastest economic growth.
(Geeky theoretical note #2: This is evident from the monetary identity PQ = MV, which implies %P = %M + %V - %Q, where P is the price level, M is the money supply, V is velocity, and Q is real output. Barring a plunge in monetary velocity that outweighs the growth rate in money itself, lower economic growth is associated with higher inflation rates. The main deflation trigger is not slow growth, but the potential for an increase in credit problems and loan defaults. That could very well cause a decline in velocity, as people increase their preference for holding safe cash, but this risk would probably be foreshadowed by a renewed widening in risk spreads between corporate bond yields and default-free Treasuries. We don't see this yet).
As I've noted before, the most likely course for the price level is not deflation per se, but dispersion in inflation rates - downward pressure on manufactured goods prices and upward pressure in the prices of labor and services, leading to an overall inflation rate that is relatively low, but positive and persistent.
Cutting through the economic theory, the simple point is that market action suggests further economic weakness.
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