For four reasons, the deflation that started several months ago is quite likely to persist along with the recession, or at least until early 2010.

First, the collapse in commodity prices continues and past declines are still working their way through the system. Crude oil prices have collapsed from $147 per barrel to around $45. Steel semi-finished billet prices were $1,200 a metric ton last summer but now is $350. Iron ore costs per metric ton dropped from $200 early last year to $80. It takes time for steel prices to work through to final consumer goods prices such as for washing machines

Second, producers, importers, wholesalers and retailers were caught flat-footed by the sudden nosedive in consumer spending late last year and continue to unload surplus goods by slashing prices. All the giveaway bargains at Christmas still didn’t entice enough consumers to open their wallets. Spring apparel, ordered before consumer retrenchment, is clearly in excess and being marked down before it’s put on the racks. Retailers from Saks on down continue to chop prices. Branded food product manufacturers are willing to promote their wares alongside the private-label goods that supermarkets shoppers increasingly favor.

Third, wages are actually being cut for the first time since the 1930s

A final reason to expect deflation in coming quarters in the U.S. is the surplus of aggregate supply over demand. Notice that the supply-demand gap is an excellent forerunner of inflation six months later. And deflation this year is spreading globally. Japan is once again flirting with falling prices, Thailand’s CPI in January fell year over year for the first time in a decade. In Europe, inflation rates are rapidly approaching zero.

Professor Nouriel Roubini says that we are far from a recovery and things will get worse before they get better :

“This time around the recession will be at least 24 months – three times as long and five times deeper in terms of GDP contraction – than the one in 2001. This time the deflationary forces are global, not just in the US and Japan as you got a severe global recession; thus pricing power of the corporate sector and earnings recovery will be weak with such sharp global deflationary pressures. This time you have the worst financial crisis and banking crisis since the Great Depression while in 2001 there was no banking crisis. This time you got the worst housing recession since the Great Depression with home prices still bound to fall another 15-20% for a cumulative fall of 40-45%. This time corporate default rates on junk bonds are predicted by Moody’s to peak at 20%, not the13% of the previous recession.  Thus, the idea that a weak US and global recovery with massive deflationary pressures and a severe financial crisis and massive corporate defaults will lead to a robust recovery of earnings and a sharp persistent bull market rally in equities is totally far-fetched.

The global economic contraction is still very severe: in the Eurozone and Japan there is no evidence of “green shoots” or positive second derivatives; and in the US and China such evidence is still very very weak. So investors and markets are way ahead of actual improvements in economic data.”

We think that this is an unusual  balance-sheet driven recession, centred on the damaged financial condition of both households and banks. These weaknesses mandate sub-normal levels of consumer spending and overall lending for about three years.

The path will be rough and the recovery Dull…

Financial markets rallied after the G20 news, though this was as much because of sprigs of good economic news emerging as the harmony that was displayed.

This was despite disappointment that the European Central Bank had cut its main interest rate on Thursday, by just a quarter of a percentage point, to 1.25%. American unemployment figures today , which can be shocking, may puncture some of that optimism, and should temper any temptation among G20 leaders to claim success. Their efforts to reflate the world economy may have avoided a 1930s-style depression so far. But rising joblessness and years of pain may lie ahead as banks, businesses and households in the West continue to struggle to pay down their debts.

The chart shows the S&P 500 since election day (along with the FTSE All-world index, which is deeply influenced by events in the US). It has fallen.

But the pattern is complex. There was a mini-crash in November, triggered by the Treasury’s announcement that it would not, after all, be buying troubled assets from the banks. 

After that, there was a 17 per cent rally that lasted until February 10, when Tim Geithner, the new Treasury secretary, made his much-trailed speech on his plan for the banks. He was not ready to reveal details, dashing many hopes.

Over the next four weeks, the S&P fell a numbing 24 per cent, before staging a rally of 14 per cent this week. It is just above its low from November’s panic.

The latest sell-off was marked by extreme fear. Individual investors, according to one survey, were more pessimistic than they had ever been. From such an extreme it was not difficult to stage a bounce on little substantial news.

Oddly, the tracking poll analogy may be a good one. It is unwise for investors or politicians to pay heed to extreme moves from day to day. But the overall trend should send a clear message – the market has twice panicked when the Treasury has raised its hopes on a policy for the banks and then lowered them. That stocks are barely higher now than in the November panic implies that the new administration has not won the market’s confidence when it comes to the banks and that it needs to do so before stock.

What´s next ?? G20 in London …