What is winning the upper hand forces of deflation or inflation?  How do we track the two forces? 

I focus on three dominant factors at the moment.  As proxies for deflation, personal bankruptcies and delinquencies and for inflation, Countrywide Credit volumes. How do I know this?  The economy is more dependent on consumer spending than ever before and housing has been driven to new highs in volume and price levels (Countrywide is one of the largest mortgage issuers in US). I believe that tracking these three forces will give clues as to which side or environment is winning the upper hand.  You have to judge this in terms of what the Fed is doing however.  For now the Fed wants to tighten and slow credit creation by raising interest rates as they have done the last two years. Recently they have kept them at high levels for the last two meetings.  The Fed sets the tone and I watch the market place for signs that the credit market is turning.

Forces of Deflation

As many people know, individuals have been racking up debt at a prodigious rate.  I would expect to see bankruptcies rising exponentially if a recession takes hold. As the consumer is more stretched than business at this point, the consumer will be the primary source of new bankruptcy. Delinquency rates are a shorter term indicator and lead the problem.

Delinquency Rates...Updated Q1'08

I need to watch these charts to see the rate of bankruptcies leveling off after the next recession.  If not, I would say the forces of deflation had taken over.

US Personal Bankruptcies...Updated Q2'07

The UK changed their law 3 years ago and the bankruptcies have been rising at an exponential rate.

UK Personal Bankruptcies...Updated Q1'07

Forces of deflation, while rising, are still small relative to the forces of inflation (a few hundred billion next to a few trillion for inflation).  However, it's worth monitoring as a runaway deflation will show on these charts.  The bigger question is whether credit is accelerating or decelerating.

Forces of Inflation

As housing has been the primary driver of the economy, I track mortgage volumes for an indication of credit issuance.  I use Countrywide Credit mortgage volumes for a proxy of housing activity.  Purchase volumes are more important than refinancing ones. The price peak for real estate in US was August'05.  This time coincided with purchase volume peaks on the moving average chart and within a few months of the year over year chart.

As you can in the second chart here, mortgage volumes are down 8% over the same period last year.  This leads to credit deceleration of a significant degree.  I believe this will lead to recession in the near term and falling asset prices across the board. 

After the falling period however, I will watch for this indicator to show positive or a growing mortgage volume.  This will indicate a return to housing.  I believe this period will also be reinforced by the Fed with negative real rates possibly leading to new highs in real estate but certainly new highs in commodities such as oil and gold.  Another possibility is government spending cushioning the fall without a rising commodity/housing market.  I will monitor Z.1 for evidence of this.

Countrywide Credit Moving Average...Updated Feb'07

Countrywide Credit Purchase Volume (Year over Year Change)...Updated Feb'07

Based on Countrywide Credit, forces of inflation are clearly falling or credit is decelerating.  When the rate of growth is below a +20%, there is no support for the real estate market.  This situation favors deflation-style investments.