US government cash may avert sustained deflation

NEW YORK, Dec 11 - Swift U.S. government action to flood the financial system with cash should prevent deflation from suffocating the economy, some of the world's best-known investors told the Reuters Investment Outlook Summit this week.

Recent government reports on inflation and unprecedented signals from bond markets have sparked talk of a return of Great Depression-style deflation, when falling prices discouraged spending and investment and delayed a recovery.

Mohamed El-Erian, co-head of the bond manager Pimco, said that the current recession would be spared such as fate by the government's commitment of up to $8 trillion to keep funds flowing through everything from American households to banks.

It may be a close call, however. The sliding economy and slumping commodities have pushed U.S wholesale prices down since the summer, and more economists are warning about deflation.

Many bond market analysts say short-term fixed-income markets indicate a brief period of deflation already may have arrived.

Yields on some U.S. Treasury bill briefly turned negative this week for the first time since 1940, meaning investors effectively paid the government to look after their cash, although a flight to the very safest assets ahead of year end may have distorted the market.

"The inflation rate will continue to come down," said El-Erian, co-chief of Pacific Investment Management Co, which runs the world's biggest bond fund. "I am less worried about depressions and deflation for a simple reason, the policy-makers are engaged."

U.S. inflation indexed bonds are pricing in negative inflation over the next five years.

El-Erian attributed this to widespread selling of assets by investors who need to cover losses elsewhere rather than an indicator of deflation. He said that prices on inflation-indexed bonds were attractive.

"I think that the falling off a cliff in terms of a depression is not the baseline," El-Erian said. "It is a risk scenario" which "becomes the baseline if you get a massive policy mistake, as we did in the 1930s, and as you did in Japan," he said.

Deflation took hold in Japan in the 1990s when the government and central bank were slow to pump money into the financial system.

Not everyone agrees that the United States will avoid Japan's fate.

"In Japan, they talk about the 1990s as the lost decade. America is making the same mistakes: we will not let anybody fail," said Jim Rogers, one of the world's most prominent international investors. He called most of the biggest U.S. lenders "totally bankrupt."

"The Japanese stock market is today 80 percent below where it was 18 years ago," Rogers noted, forecasting that the damage to the U.S. economy and stocks "could last a very long time."

U.S. economic growth is expected to contract sharply in the current quarter followed by a feeble recovery beginning in the second half of next year, analysts forecast.

While bond markets and some economic reports have sparked talk of deflation, one of Wall Street's most prominent economists said price signals were not yet flashing red.

"I would start to worry about that (deflation) if I saw a real reduction in prices of services," such as health care and education, which has not happened yet, economist Henry Kaufman said at the Reuters Investment Summit on Wednesday.

On the flip side, massive liquidity injections into markets by the Federal Reserve could stoke inflation "down the road," said Kaufman, who became known for correctly forecasting higher inflation and interest rates when he was chief economist with Salomon Brothers in the 1970s and 1980s.

"A little bit of inflation now if we could bring it about would be a helpful development. It would spur more building of inventory, more spending on plant and development," Kaufman said. (Vivianne Rodrigues and Jonathan Stempel contributed to this report)