August was a month haunted by fears of deflation, as evidenced by the massive rally in bonds that flattened the curve to below 200 bps at Augusts’ end for the first time since April 2009. The Fed has an extremely tight grip on the short end and has created a dominating opinion in the market that thinks those rates are stuck in the .5-1% area for 18-months at the very least. As for the longer-end, volatile inflation expectations and the schizophrenic safety trade has made it a scary place to invest.

Fundamentally the deflation argument has some support. The “repairing of household balance sheet” dynamic is having a powerful effect on the demand for credit. The savings rate in July was 5.9% of disposable income, down from 6.2% in June, but still 4 percentage points higher than 3 years ago. It’s healthy for savings rates to be here. Levels in 2007 were not even close to sustainable, so spending time at 5-6% is a good sign for the long-term. In addition to the household issue, businesses are hesitant to expand as the market continues to try and assign costs to new policies from Washington. As a result, the demand for credit is below the level needed for typical interest rate interventions to be effective. Banks are flush with cash because funding is very inexpensive, but they are having trouble finding acceptable ways to lend it out. The argument against deflation has always been the Fed’s willingness to ease when they saw a heightened risk of deflation. With rates already very low and the demand for credit below historical levels, additional monetary easing (QE2) isn’t likely to be very effective. In the short term inflation is likely to go lower, but true deflation is still very unlikely in my opinion.

Bernanke says “it’s not the most likely scenario”, while even after today’s data PIMCO’s Paul McCulley assigns a 25% probability to actual deflation. The August jobs report from today that topped expectations has the market pretty juiced going into the Labor Day weekend despite not being very good. In the context of the FOMC’s next meeting on September 21, this data isn’t as relevant as the market has made it out to be. The data is still putting the pressure on Bernanke, even if sentiment eased off a bit this week.

Have a great weekend.