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The stock market has stumbled for the past few sessions, but the eight-week rally preceding it certainly quelled investor concerns about deflation. Some improving economic data also have eased concerns about deflation, loosely defined as a severe economic contraction accompanied by declining prices, wages and credit.

Still, the specter of deflation continues to hover above Wall Street, although a growing number of observers believe such fears are unfounded.

Voice of Authority

"Deflation is a consequence of bad policy, not a cause of bad results," Nobel Laureate Milton Friedman, now a senior research fellow at the Hoover Institution, said in a recent interview. "Declining prices in the 1930s weren't the immediate cause of trouble. It was the declining quantity of money that produced a declining level of spending that produced a declining quantity of prices."

Friedman is perhaps the best-known monetarist, economists who believe money supply growth holds the key to the economy's path, as well as trends in inflation/deflation. He's also a controversial figure, as many blame his policy recommendations during his tenure on President Reagan's economic advisory board for the record budget deficits of the 1980s. Still, he's won at least one more Nobel Prize for economics than I have, so I figure his point of view is worth noting, at least.

From Friedman's point of view, the

Federal Reserve

has learned from the experience of the 1930s and Japan in the 1990s and is "not going to allow the quantity of money to decline more rapidly than

economic output," which he believes is necessary for deflation to emerge.

Indeed, Fed officials have in

recent weeks strained to show they understand the threat of deflation and that they will take whatever steps necessary to combat its onset.

Most recently, Fed Governor Ben Bernanke said: "The U.S. government has a technology, called a printing press -- or, today, its electronic equivalent -- that allows it to produce as many U.S. dollars as it wishes at essentially no cost." Fed Chairman Greenspan has made similar comments about the central bank's ability to inject liquidity into the economy by means beyond the fed funds rate, which is at its lowest level since 1958.

Such comments strike many observers as outrageous, irresponsible and a sign of the Fed run amok. Excessive production undermines the greenback as well as U.S. Treasury securities and -- in conjunction with the Bush administration's tax-cut-and-spend policies -- will ultimately devalue all U.S. financial assets, critics say. They may ultimately prove correct, but such actions also are very much antideflationary.

"These people may be misguided, their policies might eventually do more harm than good, but I believe them," Pimco's Bill Gross wrote in his latest report at the bond fund giant's Web site. "They will not allow the U.S. economy to deflate as long as the current regime (read: Greenspan's Fed) is in power."

Friedman's lack of concern about deflation stems mainly from the fact M2 money supply is growing at a nearly 9% annual rate. "If this degree of monetary growth continues, you will start to have an inflationary uptick," he said, suggesting "inflation is a much more serious problem vs. deflation in the U.S."

Having said that, Friedman believes there are "no immediate signs" of inflation becoming more serious, and suggested the Fed is likely to curtail money supply before its onset.

A Good Place

Overall, he believes the U.S. economy is "in very good shape," citing relatively low unemployment, strong wage growth, low inflation and high productivity. (On Wednesday, the government reported third-quarter productivity was revised upward to 5.1% while factory orders rose 1.5% in October, a bit weaker than expected but reversing a 2.3% decline in September. Additionally, the Institute for Supply Management's nonmanufacturing index rose to 57.4 in November, well ahead of expectations. The prices-paid component of the ISM report was unchanged at 54.)

Despite relatively solid economic data, "you have people talking as if this is 1931," Freidman said. "People's attitude toward the broader economy

is being dominated by the stock market. There's a relationship

but it's not a one-to-one, not even close."

Recently, I

observed that the intense concern about deflation on Wall Street is partially due to market participants' continued overemphasis of the tech sector, which has experienced tremendous dislocations since March 2000. It's probably not coincidental that fears of deflation subsided as the

Nasdaq Composite

rallied more than 30% and the Philadelphia Stock Exchange Semiconductor Index leapt more than 70% from their October lows.

If the stock market's declines of the past four sessions continue and accelerate, it will be interesting to see whether deflation concerns re-emerge.

The Great Debate Reprised

As discussed

here recently, the apparent demise of the deflationary threat has some observers wondering about the potential for a renewed bout of inflation, however modest.

"I think we've seen the bottom in inflation and through 2003 it should be upticking," said Bill Tedford, who manages about $600 million as director of fixed income strategy at Stephens Capital Management in Little Rock, Ark.

Tedford's outlook is based mainly on growth in the monetary base, which the fund manager admitted is a "more primitive" measure of money supply than M2 but one that he believes has the highest correlation with future inflation. The monetary base is the sum of currency in circulation, which the Fed influences by buying or selling Treasury bonds via its open market operations.

With the current annual growth rate in the high 8% range, the monetary base is expanding much faster than GDP growth, Tedford noted, suggesting there is more money chasing fewer goods, a loose definition of inflation. He noted the consumer price index's annual growth bottomed in July at just over 1% and was rising at a 2% annual rate through October. Tedford expects further increases into the 2.5% to 3% area.

Given such expectations, Tedford is shortening the duration -- or maturity -- of bonds in Stephens Capital's $550 million intermediate-term government bond fund, which, at 9.05%, has the top five-year total return performance for its peer group. Year to date, the fund has posted total returns of 9.79% vs. 7.65% for its Lehman Brothers benchmark index.

A little inflation isn't necessarily a negative for stocks, "but the bond market is not thinking about inflation," he said. "When the realization settles in that we're going to get an uptick

in inflation, we could get a significant repricing of interest rates."

Such a view dovetails nicely with the latest outlook from Pimco's Gross, who wrote that "the bond market's salad days are over."

Somebody should get that message to mutual fund investors, who poured nearly $110 billion into taxable bond funds this year through October vs. outflows of $26 billion for equity funds, according to the Investment Company Institute.

Aaron L. Task writes daily for In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to

Aaron L. Task.