Policymakers grapple with the effects of the downturn as the twin perils of deflation and inflation threaten global growth. Vanessa Drucker, Fund Strategy’s American editor in New York, examines the dilemma.
Economists rarely agree on anything, which makes the dismal profession lively. More than ever they are locking horns over the direction of global growth.
The markets are crying out for deflation, while the Federal Reserve and other central banks pit their arsenals behind reflationary stimulus. Over past weeks the deflation doomsters have been gaining traction, but plenty of hawks remain to warn that inflation will sneak back in a year or two.
Policymakers find themselves wrestling with a dilemma of mythological proportions. Ancient Greek mariners steered their vessels between two sea monsters on opposite sides of the Strait of Messina, one of which was a whirlpool and the other a man-devouring creature with six heads. Survival depended on maintaining a perfect balance. To steer too far from one side risked drifting into the other peril.
How long ago last summer seems. Inflation was then the chief ghoul. With oil approaching $150 a barrel, petrol prices were driving consumers to a tipping point even before the dreaded September hurricane season. Energy is required for all forms of commercial transportation, as well as construction. Another storm like Katrina could have violently disrupted the infrastructure.
But since the sudden turnaround in oil prices, along with all the other commodities, the producer consumer price indices have imploded. “If oil even averaged $75 a barrel the CPI would drop to 1.2% by year end,” suggests T J Marta, fixed income analyst at RBC. “If it should sink to $30 the CPI would go to zero.” But commodities have also fallen for other reasons beyond lack of demand. They are plunging because no letters of credit are available to buy them.
It is not surprising that opinions range so widely, considering the unprecedented economic upheaval. “With so many moving pieces, it is hard to get a handle on the next leg,” says Sean Simko, the head of fixed income at SEI. “Right now, deflation poses the greater risk, but at some point that will change, when all the money governments are pumping into the system takes hold, and inflation ticks higher.”
By the end of November, bond prices were signaling deflation expectations, as US 10-year treasuries closed below 3% and UK 10-year gilts below 4%. American inflation-indexed bonds (Tips) are now yielding more than government securities, with a positive five-year breakeven rate. They would normally yield less, to reflect inflation protection. While such meagre yields suggest that bond investors have priced out a customary inflation premium, it could still be a false alarm. In 2003, deflation proved a short-lived flavour of the month. Then, the 10-year treasury flirted with 3.07%, but soon rebounded to 4.50%. Whichever the path – extended deflation, eventual inflation with a vengeance or, in a best case, a gentler disinflation – near term, prices are headed south.
Act one: deflation:
Excess capacity is rising, with unemployment moving up. That will probably put downward pressure on prices, starting with labour rates, which account for two-thirds of production in America. “If a lot of people are out of work, especially those with higher skills, many will be inclined to take wage cuts,” suggests Alan Madian, a director at LECG, a global consulting firm. “We’ve seen that before among unionised employees in the airline industry. At the same time, the move toward outsourcing, which has gone on for a decade, will keep the lid on wages.”
The popping of the housing bubble triggered the epidemic. Falling house prices eliminated the wealth effect in terms of consumption as reverse mortgage holders could no longer use their homes as piggy banks to fuel their liquidity. The new frugality is affecting businesses as consumers prune purchases of cars and retail goods. Already firms are beginning to mark down prices, to spur sales and clear inventory. If this phase lasts, that behaviour could become entrenched, when consumers put off spending.
Shareholders are next in line to suffer, as corporate profits wane. History teaches that inflation fears normally peak in the mid phase of a recession and do not begin to recede until recovery is already on the horizon. Keith Hembre, the chief economist at First American Funds in Minneapolis, says the American recession began in early 2008, according to all broad measures, despite non-confirming GDP numbers. He says that, during the last cycle, core CPI peaked in November 2001, the official end date of the recession, at 2.8%, and then fell to 1.1% by December 2003. A decade earlier, in February 1991,the high point was 5.6%, which retreated to 3.8% by January 1992.
Although equity markets typically revive before the end of recessions, how would they behave in a protracted deflation, where a different business cycle operates? All bets may be off the table.
Jonathan Loynes, an economist at Capital Economics, is cautiously pessimistic: “We were among the first to suggest negative inflation in the UK, although the media is now obsessed with the topic.” Loynes predicts two years of contraction for the British economy, more pronounced than in other parts of Europe. Imbalances in Britain’s household sector could prolong the weakness. Continental European countries may resume growth in 2010, although Spain and Ireland are more vulnerable to housing instability.
Another symptom of a deflationary trend is the slowdown in the velocity of money, in other words, how frequently the stock of money turns over. “Some are wringing hands around the Fed’s increase in the monetary base,” says Hembre. “They are ignoring that the velocity has been contracting sharply.” They are disregarding, or dismissing, Irving Fisher’s classic formula that money times velocity equals price times quantity. With the overhang of debt levels and the weakness in asset prices, velocity is not likely to increase for some time. When it does pick up, then will be the time for the authorities to draw the base down.
No one knows for sure how prone to inflation our modern economies are. The last time it reared its head, in the 1960s and 1970s, large unions held sway in highly regulated or oligopolistic industries. American automakers, teamsters and railworkers had enjoyed a dramatic rise in living standards and espoused the faith that it was their right to keep up with inflation. Pay rises ignited further inflationary expectations. Radically different institutions populate today’s world. More global competition, less regulation, and advances in technology have changed the rules.
Balance sheets have been diminishing across household, corporate and financial sectors. Governments’, on the other hand, have been ballooning. On September 24, earning assets held by America’s Federal Reserve (Fed) stood at $1 trillion (GBP 650 billion); by November 5 they had reached $2 trillion, swelling by 133% over the course of a year. Meanwhile, those at the European Central Bank have increased by 61%, at the Bank of England by 188% and at the Reserve Bank of Australia by 85%, according to Grant’s Interest Rate Observer.
David Levy, the chairman of the Jerome Levy Forecasting Center in Mont Kisco, New York, describes how balance sheets expanded, relative to incomes, after the second world war. In its aftermath, individuals spent lavishly to satisfy pent-up demand and to replace the equipment that had been seconded to the war effort. In 1952 the household sector’s total debt constituted less than 36% of households’ disposable income. Compare that with the latest figure of 129%, which is finally starting its descent from a peak of 134%. Those balance sheets are finally shrinking, as income can no longer service the debt. However, as the rate of expansion slows, “bloated balance sheets cannot simply remain bloated”, according to Levy. “They must either continue expanding rapidly, or else profits will fall and trigger a vicious cycle.”
Levy highlights two critical distinctions between past and present epochs. Americans now can depend on lenders of last resort, including the Fed, the Federal Deposit Insurance Corporation and other government agencies, who have stepped up proactively in the current crisis. Moreover, the government performs a much larger role as an automatic fiscal stabiliser, accounting for about 20% of GDP versus 3% in 1929.
Hindsight should help. As an expert on the Great Depression, Ben Bernanke, the Fed chairman, is determined to stay ahead of the curve. Central banks have all studied the detrimental effect of Japanese deflation in the 1990s. Outside Japan there are scant modern examples of deflation to study. Price behaviour after currency crises tends toward inflation in both goods and services. In Mexico in 1994, Thailand and South Korea in 1997, Brazil in 1999, and Argentina in 2001, CPI remained positive owing to the rising price of imports. Still, it rose less than the currency devaluations, because service costs were contained, says Kanda Naknoi, professor of economics at Perdue University in Indiana.
So far, the Fed has moved aggressively, slashing interest rates by 425 basis points over the year, with another 50 likely in December; expanding loan and swap agreements; and backstopping commercial paper. The rescue efforts remind Marta of Noah’s ark: the calamitous flood will take out so many institutions in the end, the central banks are focusing their efforts to ringfence, or “get two of each onto the ark”, so as to have something left when the waters recede. Yet the money appropriated for the $700 billion “Tarp bailout” is not necessarily inflationary. Those funds are not stimulative in the sense that they replace private borrowing with government borrowing, in Hembre’s view. They represent a change in debtors, rather than an overall change in borrowing.
Which government investments will have multiplicative effects, and when? Until the impact of the multipliers becomes clearer, predicting growth is mere guesswork. By increasing or extending unemployment insurance, the government can ensure that funds will be swiftly recycled. Spending on, for instance, domestic home healthcare would show up promptly. Infrastructure spending, by contrast, would take at least 12 months to make a dent, and longer to affect consumption. “Imported inputs would result in one set of consequences, domestic inputs in another,” Madian suggests.
Act two: inflation:
Assuming we do not drown in an extended Japanese-style deflation, an inflection point will arrive. All the money sloshing in the system will revive confidence, animal spirits and lending. At some point, housing prices will reach a nadir, where people are willing to buy again. They will return to the market for mortgages, as well as a host of other home improvement items and furniture. Houses for sale and those newly purchased will need freshening up, and contractors must be hired.
Hopefully, a new business cycle will germinate, with limited second order effects. But the hawks are not so sanguine. They look to burgeoning budget deficits, which could impose higher interest rates to attract capital. “Foreigners may shun treasuries and the dollar could plunge,” says Axel Merk, who runs the Hard Currency Fund from Palo Alto. The Fed is monetising the system by buying up debt securities and providing cash in return. If it cannot mop up the liquidity when the economy recovers, inflation could rear with a weakened greenback. “The rush into treasuries and the dollar is panic buying. When the situation normalises, the money will not stay in the US.”
Loynes says: “Those who worry about inflation tend to be of a strong monetarist persuasion and fear the explosion in public sector deficits and the measures central banks have taken to boost liquidity and money circulation.” Since September, when the Fed embarked on expanding the credit side of its balance sheet, it has provided an array of facilities to create “quantitative easing”, which targets the quantity rather than the price of money. At the same time, it was initially sterilising the impact by adding to its liabilities, as the US Treasury deposited funds in the central banks, which the Treasury was raising in the open market.
So the two activities were netting out. In late October, however, the Treasury deposits fell, while the Fed began to flood the banking system with excess liquidity in an effort to spur the banks to lend. Thus it is increasing the supply of money, following the example of the Bank of Japan during the 1990s. If the gambit works, the aim is to stimulate the economy while interest rates hover dangerously close to the floor of zero.
At the end of the day, as governments race to open the spigots, the money has to come from somewhere. “Governments per se do not have any money,” reminds Mike Martin, chief financial officer at Financial Advantage in Columbia, Maryland. They have only three ways to raise it: they can sell bonds to private investors, or raise taxes, or turn on the printing presses.
They are indeed selling bonds now, and at obscenely low interest rates, but “this too shall pass,” Martin predicts. Raising taxes, the second leg, eventually becomes counterproductive. “High marginal tax rates discourage investment and entrepreneurial risk taking, which dampens the pace of the economy and shrinks the taxable income base,” says Martin. Tables from the Office of Management Budget show that federal revenues tend to cluster constantly in the 18% to 20% range, with little regard to tax rates. That leaves the last leg, the printing press, which can undermine trust in the buying power of a currency.
Some would respond that since so many central banks at a time are debasing their currencies, perhaps the net effect would wash out. Merk, however, fears that a weaker dollar would lead to inflation in America, while he says there would be one main winner: China. A falling greenback could give a new push to commodity prices, which are still priced in dollars and often move inversely. Meanwhile, as the credit crunch subsides and trade begins to flow more normally again, commodities could enjoy an additional boost.
A reversal from contraction to inflation would depend how quickly the central banks act in reverse, to take away the punchbowl. James Berman, the head of JB Global in New York, stresses how monetary policy, like markets, tends to overshoot.
With the banking system so fragile now, authorities may err on the side of overaccommodation. After the collapse in 2001 and 2002, lower interest rates fuelled inflation among financial assets and property, although not goods and services. “It was just another type of inflation,” Berman says. “We might see inflation overshoot to the upside, if the government continues printing money with three hands, and the dollar reverses because of concerns about treasuries – the ’new subprime’!”The deflation camp makes constant references to the spectre of the Great Depression, but Berman disagrees, saying, “we are still in the wake of the greatest monetary expansion ever.” Modern American and European economies are quite unlike those of the 1930s. Eighty years ago, agriculture and manufacturing overwhelmed the much smaller services industries. The former, especially farm commodities, were much more vulnerable to boom and bust cycles than are services and technology.
On the other hand, a renewed surge in commodities, especially oil, could swiftly feed through to economies worldwide. We experienced a nasty taste of that during the first half of this year. The price of energy depends on several key factors, apart from the demands of industrial growth. Geo-political crises, especially in the Middle East, damaged pipelines and infrastructure can quickly disrupt a delicate equilibrium, with alarming potential against any backdrop of rising inflation.
For years it has been a truism to talk about how the global economy is in flux. But just since September, and the watershed moment of the Lehman collapse, the word has taken on a new meaning. Only a few months ago decoupling was still the buzz, and supported the faith that emerging economies could absorb the downturns from the West.
Even the vaunted Brics (Brazil, Russia, India and China) are stalling, and implementing their own stimulus programmes, which would have been unthinkable last summer. Remember the clamour of concern about hyperinflation in July. It should be no surprise to see another rapid switchback.
Finally, for those who wonder how Odysseus managed to save his ship from the twin perils of the two monsters, his solution was to choose the lesser of two evils. He knew there was no way to avoid losing everything, if the whirlpool Charybdis sucked him down. Instead, he sailed fast, closer to Scylla’s snaky heads, and sacrificed six of his sailors, not pausing to fight her.
By a similar token, policymakers recognise that prolonged deflation poses the more sinister threat and is more difficult to reverse than inflation. So they are ready to stimulate by all possible means, planning and hoping to move adroitly enough to stem inflation’s bite on the other side.
Japan’s protracted period of deflation
Japan demonstrates the most glaring model of an economy plagued by an entrenched deflation. Since 1995, prices there struggled in negative territory, suffering a further blow in 1997, when the Asian contagion crisis hit Japanese exporters.
Only this year, for the first time, has Japanese CPI measured positively every month, year-over-year. Yet despite its 1.9% rise in October, that marks a 0.4% drop from September’s increase.
Meanwhile, industrial production plunged 12% this autumn, and deflation lurks anew. “Prices of goods fell more than services in the 1990s,” says Kanda Naknoi, an economist now at Purdue University, who was living in Tokyo during those years.
The Japanese labour market is less flexible than that in America, where it is easier to lay workers off and to cut wages.
She expects to see a correction in America in both goods and services. But unlike Japan’s, the American population is still growing, which should support productivity. Another distinction between the countries is that of property ownership.
Although in Japan a commercial real estate bubble burst, home ownership is much lower than in America or Britain. Naknoi (pictured) recalls that falling apartment rents were the clearest anecdotal sign of the slide in prices.
Liberalisation in services, such as the deregulation of Japan Telecom, also sparked competition and pressured prices. “In Tokyo, consumer electronics were always on sale, at bargain prices,” Naknoi adds.
“The Japanese take price as a quality signal. When firms lowered prices, people became even more sceptical that something was wrong.”