The folks at Hoisington Investment Management are out with their always excellent, always well thought out quarterly analysis. Despite signs of inflation in many places, they say, rising unemployment, lackadaisical consumers and a slowing world economy make deflation more likely than further inflation.

Widespread is the notion that inflation is back for good. Many assume that the relative price stability of the past two decades has been irrevocably shattered by “peak oil” and the surging demand by developing economies. Improvement of living standards in those developing countries has caused, and will continue to cause, increasing demand for calories, and final demand for food will outstrip supply. Additionally, the cost of basic materials is lifting production costs, and the cycle of higher food and fuel costs means that the prices of all imported goods to the United States will continue to rise...

Our conclusion is that deflation, not inflation, is, and will continue to be, the essential problem for the U.S. economy and that the optimum fixed income portfolio should consist of treasuries with the longest possible maturities...

The unemployment rate has risen to 5.5%, the highest level since October 2004, while the manufacturing capacity use rate has fallen to 77.5%, the lowest since November 2004. Since 1949, manufacturing capacity utilization has averaged 8.%. As such, there is an additional 3.6 % of excess capacity. The output gap, which is real GDP less potential GDP as a percent of real GDP, was an estimated -2% in the second quarter, the largest amount of economy wide excess capacity in five years (Chart 4).

These measures also confirm our prognosis for aggregate prices. The higher unemployment rate points to downward pressure on wages and benefits. This is clearly happening since wage gains have fallen to 3.4%, down 0.9% from their cyclical peak. The low rate of manufacturing plant use indicates that firms do not have pricing power. As such they are unable to pass through higher fuel and raw material costs, thus squeezing their profit margins. The negative output gap confirms the excess supply in the labor and production markets and also points to lower inflation