It’s a deflation déjà vu. The looming Lost Decade. The exfiltration of inflation.
The summer of 2009 was characterised by one almighty debate between those expecting Japan-style deflation, those who forecast inflation — and those who thought monetary conditions would be ‘just right.’
(Where, we ask, are the stagflationists?)
Fast forward a year and we’re having the same argument, though the emphasis has shifted dramatically. The deflationistas appear to have suddenly grabbed the upper hand.
Wells Fargo economists Mark Vitner and Azhar Iqbal have come out with a timely special report titled, “Understanding the risk of deflation.” And it really sums up the sentiment-shift. As they write:
The reason monetary policy will need to be more proactive today is that the potential risks from a persistent, destabilizing deflation are much greater than the potential longer-term costs that inflation might accelerate. Moreover, the economy may already be at the point where we are only one more negative shock away from a problematic deflation. Inflation is already lower today than it was back in November 2002, when then Fed Governor Ben Bernanke delivered his widely cited speech on the subject titled Deflation: Making Sure “It” Doesn’t Happen Here. Unfortunately the list of potential stumbling blocks is uncomfortably long right now. While predicting Black Swans is hazardous, notable tripping points include the European Sovereign Debt Crisis, the precarious position of many state and local governments in the United States, and the growing resistance to additional fiscal stimulus in Europe and the United States amid what appears to be slower global economic growth.
Monetary policy will need to be more aggressive, because the Fed’s other unconventional easing measures have largely run their course. Extending the “extended period of time” language on short-term interest rates now appears to add little value. The financial markets have already priced in a much later upturn in short-term interest rates, and bond yields have tumbled following the deterioration in global economic prospects following the European Sovereign Debt Crisis. Reducing the already rock bottom interest rate paid on bank reserves would also have a very limited impact. That leaves just two policy options, reinvesting the proceeds from maturing bonds in new Treasury bonds or embarking on another round of massive securities purchases.
. . .
The shift in attitudes about deflation from something that might be remotely possible to something that is to some extent certain can not be overstated. Deflation worries are now front page news, and economic conditions will likely intensify these concerns in coming months. The catalyst for the increased attention was a 21-page paper issued by Federal Reserve Bank of St. Louis President James Bullard, titled Seven Faces of “The Peril”, as well as the weak second quarter GDP report, which showed the economy expanding at just a 2.4 percent pace and final demand rising at an anemic 1.3 percent pace. Other points of concern include the recent slide in Consumer Confidence, particularly with regard to employment and income prospects, and the larger-than-expected build in inventories during the second quarter.
The key takeaways from Bullard’s paper are that the U.S. economy is currently closer to Japanese-style deflation than at any other time in recent history and that quantitative easing would be the best way to deal with any negative shocks that further exacerbate the threat of a destabilizing deflation. Words of warning from a Fed president are nothing new, and we have a dozen of them with varying opinions on just about every issue. What is most relevant in this case, however, is the warning comes from a Federal Reserve Bank president and voting member of the Federal Open Market Committee generally regarded as an inflation hawk. In addition, Bullard is the president of the Federal Reserve Bank, which tends to lead the way among district banks in monetary research. If there is a reason to be concerned that someone at the Fed is concerned about deflation, James Bullard is one of those people.
We believe James Bullard’s concerns are valid, but they should not be exaggerated. Technically speaking, deflation is already occurring. Both the Consumer Price Index and Producer Price Index have declined for three consecutive months. Moreover, our forecast for inflation during the second half of this year shows the year-to-year change in the Consumer Price Index trending toward zero by year-end, has the core CPI rising just 0.8 percent, the Producer Price Index and the core PPI both rising just 0.8 percent, the personal consumption deflator and the core personal consumption deflator climbing just 1.0 percent. This is as close as we have ever been in the modern era to declines in this many headline and core inflation measures. All of these measures are below the Fed’s target range, which removes much of the buffer Ben Bernanke has argued in the past is necessary to defend against deflation. In addition, inflation has shown a tendency to slow during the second year of an economic recovery, which we are now entering.
Whether these levels of ‘borderline deflation’ evolve into a more problematic deflationary spiral depends, as the Wells economists note, on how long they persist. And that in turn largely depends on the state of the economy which, as the WF guys also add, isn’t looking too hot right now:
The sluggish growth reported for the second quarter is even more alarming because it appears economic conditions deteriorated over the course of the period and the current quarter appears to have gotten off to a sluggish start. Increased government outlays and stimulus-induced spending accounted for all of the economy’s growth and then some during the second quarter. With so many of the various stimulus programs either having already ended or now in the process of winding down, where will economic growth come from?
And since this analysis wouldn’t be complete without actually trying to quantify the threat of deflation — the Wells econoboffins have used something called a Hodrick-Prescott (HP) filter to isolate the long-run trend in price indices from short-term cyclical movements.
If inflation measures significantly deviate from the trend :
. . . then there is a reason for policymakers to take notice, particularly if the deviation occurs across a number of price measures . . .
And boy, has it ever.
Wells have applied the filter to three core price measures (CPI, PCE deflator and PPI) then averaged them out to get an HP-filtered core inflation index of sorts. And that index is at it’s biggest negative deviation since January 1985 — the starting point for the Wells analysis.
Inflationistas, avert thine eyes:
Why is deflation bad? – Paul Krugman, NYT
Deflation fears gain upper hand as debt crisis curbs growth – FT
That receding, deflationary, resurfacing … M3 money supply – FT Alphaville
Deflation dead and deader, Federal Reserve-style – FT Alphaville