Some Random Thoughts on Deflation

Today marks precisely one month that yours truly noted that he was swamped. He still is, but even though your author is still struggling to meet the quantitative demands of neo-classical graduate economics (especially, the statistical vintage) he still thinks that now might be as good a time as ever to jump back into the saddle and practice some economic punditry. After all, this is something he, much unlike graduate econ math, is quite familiar with.

Needless to say, it is difficult to know where to start but since I am only now returning from an extended pause it might a good idea to pick up one of the themes I laid out just before the anvil of quantitative science hit me. Consequently, one thing that I have been persistently noting in my ongoing analysis of the global economy has been the risk of deflation in key economies due to the dramatic decline in domestic demand and credit momentum.

Specifically, I have been warning that when it comes to the old economies of the world (measured by median age) the risk of a deflationary backdrop is particularly large. The argument here is really quite straight forward in terms of economic dynamics and basically hinges on the idea that relatively old economies do not have sufficiently dynamic internal demand conditions to prevent their economies from falling into deflation. Obviously, the risk of deflation can hardly be confined to these economies at this point and what we are facing now is a potential scenario of global deflation both in terms of core and headline prices as well as of course asset prices. At least I would say without sounding too doomist that this is now a real threat.

Deflation Coming to a CPI Near You?

A couple of months back I sketched my thoughts on the topic as I asked the simple question of whether deflation would be the next macro story. As the carnage in global finance continues and as the effect on the real economy is increasingly making itself felt I am sure most analysts and observers feel a bit shell shocked. I know that I do. Consider consequently the recent news that consumer prices in the US fell a whopping 1% on a monthly basis which more than suggests how the threat of deflation is mounting.

Of course, the monthly decline in consumer prices masks a healthy y-o-y growth rate of some 3.7% (2.2 in core prices) which does not exactly spell deflation in any sense of the word. However, the negative momentum must be considered here and in particular the fact that the global economy has gone from a situation of liquidity disruptions confined to the wholesale banking market, over to a severe credit crunch in terms of firms operational finance and on to what must now be considered a complete freeze of lending to all agents. On the back of the recent barage of execrable news from the US, JPMorgan rolls out the inevitable prediction that the Fed and Bernanke may even introduce some form of ZIRP to counter the recession.

And speaking of ZIRP we learned yesterday from Japan how exports sank the fastest pace in seven years which also prompted analysts from Barclays to suggest that Japan would return to deflation and that the BOJ would have to re-introduce ZIRP accordingly.

click to enlarge
I don't know whether the good lads at Barclays had to dig deep to come up with this call; needless to say that deflation in Japan is now a foregone conclusion as we venture towards 2009 and the previous sharp dose of cost push inflation tapers off. At the BOJ, rates were kept at the odd 0.3% yesterday and while there may be an strong inclination not to cut rates to 0% for simple reasons of credibility I do think that they will have to bite the bullet as we move forward into this slump. In a general global context, I think it is important to recognise the massive negative shock we are seeing on demand conditions in those nations who have hitherto been living high on credit and since the credit channels are now firmly broken, so will those macroeconomic credit providers (read: exporters) also suffer .The epitomy of this must clearly be Japan but also Germany comes immediately to mind.

And now that I am talking about Europe, the deflation ghost is also here hovering like a dark shadow over the economic edifice. Of course, and as a hell of a lot more than the proverbial Rome is burning I am not sure what the ECB will do here? It is true that it seems that European policy are content with flexing their fiscal muscles while Trichet et al. remains in the ivory tower where the M3 presumably is still growing above target and where only a definitive drop in consumer prices below 2% would seem to allow the ECB, in a postmortem perspective, to really act along the lines of its other CB peers. At this point I will give the ECB the benefit of the doubt in the sense that we have indeed observed a real change of strategy, but given other CBs' response the ECB seems still, to be the odd man out.

That may change quickly though. The Spanish representation at the ECB roundtable certainly seems to be predicting a dire potential outcome which, given the state of things on the Iberian peninsula, it is difficult to second guess.

European Central Bank council member Miguel Angel Fernandez Ordonez forecast an ``enormous'' drop in euro-region inflation. Bank of Spain forecasts for the 15-nation euro area ``show an enormous moderation in price gains, but they do show price gains,'' Ordonez, who is also governor of the Spanish central bank, told reporters in Madrid today. The forecasts ``don't show deflation,'' he said.

As in the US we are far from an actual state of deflation, but given my argument as I laid it out (see link above) the negative momentum we are observing suggests that what comes next on the macroeconomic front may be quite "unexpected" as those ever incoming stream of Bloomberg headlines are so fond of noting. If we look at the evolution of data the interpretation is quite clear. As can be seen from the graphs below, the decrease in inflation is currently being produced solely as a function of declining headline inflation (this is the same picture as the one emanating from the US and Japan).

More generally, it is hard not to think back to the days when Trichet was playing tough on inflation, when CEE central banks revalued as there was no tomorrow, and where moral hazard (or traitor?) was pinned on all those who had the temerity (I positively love that word!) to argue that something had to be done. Clearly, we are past that now and to steal again the analogy conjured by my colleague Edward Hugh; what is the point in having your throat slit alongside your enemy's just to see who can run the fastest before bleeding out? Clearly, not the most productive of endeavors I would say.
Meanwhile and returning to the graphs one last time it seems as if, once again, one of Macro Man's metaphors will be useful; more specifically I am talking about the one in which Trichet does the humpty dance (now, there is a party I would attend!). Do you see a hump sir? I do.

Obviously it is never so simple. First of all there is the good old sticky price phenomenon which is also present in the graphs where headline (cost-push) inflation is coming down rapidly but where core inflation naturally will need more time before adjusting to the economic fundamentals. In this way, and if we pull out the oldie but goldie dichotomy between the Anglo-Saxon and Continental European economies conventional wisdom would have it that prices (and wages) adjust more more slowly in the latter. In some ways this would merit the divergence between the Fed and the ECB in tackling this mess. However, I am not sure such MD/SAS analyses apply in this case. More specifically, what I am looking for in particular is what will happen in the transition as many economies now will need to depend more on external demand to achieve growth. Remember here that all those rescue packages need to be paid for and domestic demand in itself will hardly do it. For the US et al. a reduction of external imbalances will be of material importance.

Thus, I am also sure that we have the whole rebalancing/global imbalances discourse knocking around somewhere in the background. Yet, I am just not sure that the ECB can "help" the US by keeping interest rates up and by derivative "offering" the Eurozone as a shoulder on which the global economy can lean for demand. Add to this of course that the market has already discounted the incoming recession through the absolute slaughter of the EUR/USD.

In this sense the ECB may get double pinched since if they lower rates further (and one has to assume that they will) it could take the Euro to a level where the objectives of policy would be in conflict in the sense that rates would have to be kept higher than otherwise to avoid the Euro to fall in the .9-.8 region. In some ways, this is would square well with the likely growth path of the "future" Eurozone as an economy driven less by domestic demand than has hitherto been the case. And yes, you heard me right, there will be much less domestic demand to go around in the Eurozone and indeed the entire EU 27 once the corrections in Spain and Eastern Europe becomes clear for everybody.

And thus we end up at one of my favorite hobby horses (I have several). In a world where governments are presiding over aging populations and faced with a major overhang of debt in the context of fighting this behemoth of a financial crisis, the incentive to try to burn up the debt through inflation (and for all things in the world, to avoid deflation) and thus by derivative export your way out of trouble is massive. I would hold this to be true even without the particularity of the current situation in the sense that as the world ages so does the number of economies dependent on external demand grow. In fact, it is precisely this "incentive" to be export driven I think it is so crucial to pin down in both a practical and theoretical sense, but that will have to wait for another day.

Comments

[Charles Lon...:]

The money supply has been blamed as a factor in deflation as that money supply is reduced. However, other definitions of “deflation”, (wikipedia), refer to dual contributing factors: decrease in money supply, and decrease of credit. To what extent is decrease in availability of credit a contributing factor to deflation? If credit is considered beyond common types to include leveraged amounts, as per derivatives and other instruments for leverage, (often leveraging many times over by exotic investment vehicles), could this provide an answer as to why printing dollars has so far not stemmed deflation, and theoretically may not create inflation until the leveraged credit that is no longer available is offset by new dollars?

2008 Nov 22 12:32 PM

[Dr Greenspam:]

Truly random thoughts - very hard to follow.

2008 Nov 22 12:37 PM

[Charles Lon...:]

I apologize. To be clear, I am suggesting that printing money may not create inflation until a balance is obtained. Imagine a traditional weight scale. On one side of the scale we put money, lots of it and increasing the amount in an attempt to raise the other side. The other side of the scale is the total of all credit that is no longer available. It that credit includes leveraged amounts, you will be able to keep printing money a long time before tip of the thing moves towards inflation.

2008 Nov 22 12:45 PM

[NOWHEREMAN:]

How will the Resale of Foreign held USD back into the world markets impact the USD?

Accelerate the pace of the perceived current noninflationary rise in the amount of dollars from deflation to inflation?

China is repackaging its USD into Dollar denominated Bonds and sending them back into the World; Roughly $70 Billion so far, tranches of $3.3 Billion at a crack, 23 so far. If I can receive this info, how long will it take the rest of the world to "get" it?

People's Daily, online edition.

2008 Nov 22 01:50 PM

[granger:]

Interesting read,but must admit I am a believer in long term inflation. Thank you for your thoughts.

2008 Nov 22 05:04 PM

[Hmm?!:]

Are you saying the USD received from exporting to the US.... is returned to the US by buying American debt?

Then the chinese are caught in the same death spiral? How should they respond? How should America respond?


On Nov 22 01:50 PM paultaut wrote:

> How will the Resale of Foreign held USD back into the world markets
> impact the USD?
>
> Accelerate the pace of the perceived current noninflationary rise
> in the amount of dollars from deflation to inflation?
>
> China is repackaging its USD into Dollar denominated Bonds and sending
> them back into the World; Roughly $70 Billion so far, tranches of
> $3.3 Billion at a crack, 23 so far. If I can receive this info, how
> long will it take the rest of the world to "get" it?
>
> People's Daily, online edition.

2008 Nov 23 01:54 AM

[NOWHEREMAN:]

It took 16 years for the DOW to break 1,000 and continue to go up. That BULL run is still intact if you use your straight edge from the 1982 low connect the 1987 low and extend out to the present. That direct line is around 6,000 for the 2008-2009 time frame. It is also a .618 retrace of the entire move above 1000 or 13,300 intraday.

That's my line in the sand, DOW 6,000. To me, going below that point will allow for a repeat of 1929 where the Djia drops 90% from its peak and unemployment soars to 25%.

GM and its unions have made drastic changes on its cost front but those changes were made months ago. The losses they are incurring takes those reductions into account and the economy is supposed to get worse before it gets better. They need the $50 Billion for themselves.

Meanwhile, People are in arms against the Bailouts in the Financial Arena. Without ripple effects, the Financials employ 6.6 Million people. Which is more important? The Fat Cats at the top, Tax the hell out of them. How about the Bank Clerks at the Bottom?

A Bank clerk looks at a GM Union worker the way GM's Unions look at top management. There are a hell of a lot of people who make far less than an assembly line worker at the Auto Unions, including all benefits.

Obama plans to Tax the top 5% and lower Taxes for the other 95%. The Rich are called Rich because they can afford to pack up and leave the country. Who will be the next in line? The top 1% pay 40% of all income taxes.( I'm not positive on this figure, something I read somewhere).

The economy that Obama inherits will be far different than the one he made Campaign promises about. I can only hope he has the ability to Change himself.

2008 Nov 23 02:47 AM

[Greg Pinelli:]

I'm at a loss why you even wrote this massive piece of entanglement. Not only are you "swamped"..you're lost. Deflation and inflation aren't discrete events..they are ongoing and simultaneous. The REAL question is where each pops out..who it affects..and which one eventually controls the larger economic picture. Without question it will be inflation. Deflation causes too many control issues and the same people who need to manage and control populations also control money and credit. What we are seeing now is a building of the new liquidity foundation...and the outlet will be huge and unstoppable.
See..that wasn't so hard..was it?

2008 Nov 23 11:35 AM

[Greg Pinelli:]

What can "paultaut" possibly be talking about??? Every form of money is accelerating rapidly..take a look at M1. What sense does it make to take US $ out of one investment..and repackage it into the same currency and resell it???? How can a wash sale possibly increase anyones perception of inflation?? Peoples Daily? Please.

2008 Nov 23 11:40 AM

[Charles Lon...:]

ok. Good sourcing. What does it say about inflation and the US dollar? Are you saying inflation of the USD is inevitable or not?

2008 Nov 24 12:08 AM

[NOWHEREMAN:]

Inflation is a gimme, its the only way out of the present quagmire. We are doing the exact same thing that Japan did a few decades ago. We may be doing it differently but the end result is the same, Government ownership of private assets to ensure survival will prolong the downturn because they will continue to suck money out of the Government without altering their business models.

Bankruptcies by companies with similar models ensure change. The Bailouts have to stop. But I don't think they will: Citigroup how much will it cost to save?

At some point, the rest of the world will realize that the printing presses will not stop. The US will have more Debt outstanding than it can possibly repay at current Dollar levels. Once the "flight to safety" ends, the dollars rise ends. Many have said that the Euro and EU would fall apart, personally, I think it has grown stronger in Crisis.

I don't know when the slide will start. I would expect inflation to rise abruptly next year if what I have heard of the Obama stimulus package is true. Infrastructure construction and repair is notoriously energy intensive. Look at the inflation rates of the Asean Zone when they were growing strongly doing the very same thing.

Will the Dollar rise as oil rises again? I don't think so. Thats the cue, IMHO.

PS Please consider the following: the Saudi's currently produce 4% of the World's aluminum supply, they expect output to increase to 10% within the next 15 months. Qatar is in the process of constructing a 1 million square foot Solar Manufacturing facility, capable of 6 meter solar panels. Iran is constructing 8 steel plants simultaneously. They are building their own Industrial base while a Construction slowdown is being advertised in Dubai.

GM announced plant closings over the weekend. Toyota opened a plant in Kentucky this weekend.

2008 Nov 24 01:49 AM

[Charles Lon...:]

Well said! Whether gold or oil is the early harbinger is somewhat irrelevant. I agree that a move up by either, as the dollar does not, would be a divergent cue.
Spike and tease plays not considered.

2008 Nov 24 02:07 AM

[Perry B:]

I just wanted to weigh in on a totally unrelated issue. Yet a valid point. All this macro-micro economics and talk of deflation and inflation could be solved by america doing what Americans do best. Be capitilists and build a better mouse trap. Give the consumer a product he wants to buy. My example would be automobiles. If a train can haul one ton of product 423 miles for one gallon of fuel using generators for power and the engine to power the generator. would it not stand to reason That GM instead of closing plants could retool useing this technology and move a two ton automobile 423 miles for two gallons of fuel? Would using this technology not spark a global demand for thier product? Bringing more jobs,pumping up the local auto industry as well as exports and a partial solution to oil dependency? If not solving the bailout issue of throwing money into a bottomless pit rather offering assistance to make this retooling a reality? With the National banks soon to be totallly controled by the Government, leaving local lenders powerless to grow thier local economy, unless the loan applicant fits the standard government loan app. Free enterprise in America is dead. No macro or micro money manager seems to be interested in the fact that consumers no longer want to buy the same old bread in a different wrapper. Talking heads are as obsolete as the dinousaur to the average american. Myself included. Until everyone in the manufacturing process as well as our government wakes up and realizes the need to change our whole National product line from the way we drive to what we eat. Get back to what made America great in the first place. We are going to be stuck in this very boring quagmire of I " think" verses the creative mystery that made our Nation great and a true world leader that exported products and idea's. Manufacturers and the American people need to retool minds, so once again a bright spark can boldy say. "Hey I just sold a million widgets because they are new and innovative and work for the peoples future needs". Not based on numbers and corporate greed but genuine true need. Until we can say that, and develope the mindset that goes with that thought. We as a Nation are going to continue spinning in this circle of doom and gloom and macro micro economics with no beginning and no end. Just daily moving dollars. How boring and counter productive to our purpose on this planet. Not to mention a sad legacy to leave the next generation with. Well that is my rant. Have great trading day.

2008 Nov 25 12:27 PM