Which Way are We Going?

That is the question, at least in terms of the inflation/deflation debate that is incessantly raging across the financial blogosphere lately.

Barry Ritholtz over at The Big Picture (the original one) points to a rather pithy and cogent analysis of the downtrend in the economy thus far, by David Rosenberg of Merrill Lynch:

"There have been five phases to this current down-cycle – the first four are still in full swing, but it is the fifth that will very likely emerge as the most difficult stage of this economic downturn and bear market:

• The first wave was the end of the housing cycle when starts peaked and began to roll over in the first quarter of 2006.

• The second wave was the end of the home price bubble when the Case-Shiller index began to deflate in the first quarter of 2007.

• The third wave was the end of the credit cycle when the interbank market froze in August 2007.

• The fourth wave was the employment cycle, which peaked when payrolls did in December 2007, prompting the Fed to reluctantly embark on an aggressive policy easing course.

• The fifth wave will be the end of the consumer cycle and the beginning of what may well prove to be the most significant recession since the mid-1970s, and while delayed by the tax rebates, this phase seems to have commenced in June when U of M consumer sentiment collapsed to its lowest level in 28 years."

Going forward, Ritholtz notes, Rosenberg is more concerned with deflation than inflation, which seems about right -- at least in the longer term, and at least in terms of asset deflation.

Housing, which is already down almost 30%, still has a long way to go, as the Option Arm fiasco approaches this summer and as rising rates and surplus inventory continue to put downward pressure on prices. Because those rising rates aren't likely to be seen from Bernanke until after the election, we can almost guarantee that the true housing bottom is at least a year away, in the summer of 2009 -- and probably longer.

But at some point the market, if not the Fed, will address inflation through much higher rates than we've seen in the last decade. Those higher rates will force not just housing, but equities and bonds down through the floor.

And that will be after this long summer grinding of the Dow.

Welcome to the bear market. It'll be here for a while.

(For an explanation on how interest rates will push asset prices lower, visit today's post from Charles Hugh Smith.)

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