Yellen's Stagnation View: A Real Possibility?

San Francisco Fed President Janet Yellen recently said there is no real threat of an inflation surge, and is instead expecting inflation to fall to around 1% over the next year. She also believes the risk of inflation remains very low, and that interest rates could remain near zero for several years.

Her commentary is in sharp contrast with numerous analysts and economists, who have argued that the government's massive liquidity injection and quantitative easing program will result in stagflation or even hyperinflation as soon as economic activity picks up.

What Yellen described is essentially stagnation, or economic stagnation, which is a prolonged period of slow economic growth, traditionally measured in terms of the GDP growth. Under some definitions, growth less than 2-3% per year is a sign of stagnation.

Japan has experienced economic stagnation for fifteen years. Adverse financial developments were at the center of Japan’s economic morass, which is no different from our current financial and banking crisis. Although recent data points to a gradually healing economy, the following are factors supportive of a stagnation scenario:

Extremely High Debt Levels

Between 1982 and 2007, the amount of total debt grew from $1.60 to $3.53 for each $1.00 of GDP. This was made possible as the cost of money fell from 15% to 20% in 1982 to the current near zero interest rate. As interest rates fell, consumers were able to take on more debt. Increased consumer debt levels boosted GDP over the last 25 years. Household debt has increased from $.44 in 1982 to $.98 for each dollar of GDP in 2007.

Higher Savings Rate

Columbia University professor Edmund Phelps, winner of the Nobel Prize in economics in 2006 said U.S. households may take as long as 15 years to rebuild wealth lost in the recession. U.S. household wealth fell by $1.3 trillion in the first quarter of 2009 after dropping by a record $4.9 trillion in the 4^th quarter of 2008.

In addition, the largest demographic cohort in the history of mankind, the post WW II baby-boomer generation, has passed its spending peak. This is going to be a decade-long process of less spending, of more saving, and above all, of paying off excessive debt and recouping the wealth loss in this recession. The economic consequences are going to be profound and will affect all sectors of the economy.

The personal saving rate fell to near 0% in 2007 and early 2008. The last 12 months of the current recession have motivated individuals to increase the personal savings rate to 6.9% as of May 1, 2009, the highest in 15 years. This is part of the reason why the economy has been so weak since consumer spending represents 70% of our GDP.

Grim Labor Market

The gloomy job picture threatens any economic recovery. The unemployment rate hit 9.5% last month. Many now expect it to stay high for a long time, eventually reaching double digits. The broader measure of underemployed also rose to 16.5% in June. The latest employment figures indicate that with another 900,000 job losses by the end of the year, which is likely, an entire decade of employment gains will have been wiped out.

The U.S. industrial capacity utilization rate stood at 68.3% in May, a historic low. With so much excess capacity, businesses will not have to materially increase investment for at least the next 2 or 3 years. People facing unemployment or wage cuts are less able or willing to spend to stimulate the economy. One economic theory, the Phillips Curve, which is a historical inverse relationhip between the rate of unemployment and the rate of inflation in an economy, posits that such excess will reduce inflation as firms with idle capacity cut prices and workers facing layoffs accept smaller wage hikes.

Banks Are Not Lending

The level of lending is an important factor in determining how fast the economy will turn around. Lending at the biggest U.S. banks has fallen more sharply than realized, despite government efforts to pump billions of dollars into the financial system.

According to a Wall Street Journal analysis of Treasury Department data, the biggest recipients of taxpayer aid processed 23% less in new loans for February, the latest available data, than in October, the month the TARP program was initiated. One factor that may have masked the still tight credit conditions is the partial thawing of the corporate bond market, with a return of investors risk appetite seeking higher returns. About $70 billion in corporate bonds have been issued in February, up from $21.4 billion in October, but still only about half the level of last May, according to Thomson Reuters. However, the corporate bond market, where big companies go to raise capital -bypassing banks, are drying up quickly as well.

Conclusion

Indeed, the era of excessive spending and debt is over. For now, a quick resurgence in inflation is only a remote possibility. There is nevertheless a possibility, considering that central banks tend to have a hard time knowing when to take the punch bowl of “excess liquidity” away. The banking system remains crippled. Lending standards are high and are not coming down, as banks work to lower their leverage ratios from 30 to the low teens. An economic recovery will be unlikely until producers exhaust their existing capacities. Debt levels are so high that any increase in interest rates will impose a significant burden on consumers and the economy, thereby stunning growth.

On the other hand, in a near 0% interest environment, investors will need to take more risks to garner higher returns. It's also unlikely that the stock market can keep up a 9%-a-year average return as asset values stay depressed. So the wealth effect is not going to be increasing any time soon.

Therefore, the near term inflation concerns are overblown, as we are still in a deflationary environment. Unlike Yellen, who projects stagnation for the next 2-3 years, I could envision the scenario playing out for the next 18 months. In my opinion, any stagnation projections beyond 18 months are highly speculative, and reliant upon too many unknowns to be reasonably considered at this time.

Comments

[Tom Colangelo:]

The market will continue to move sideways based on the numbers and guidance given this week BECAUSE:

1) FIRMS will say nothing or say that the outlook looks better than the recent past. It would be a SELF-FULFILLING PROPHESY if companies with weak Q2 results give negative guidance for Q3. A literal death wish for any firm saying that they won’t improve their numbers even though the economy is beginning to level out and the stimulus is still gaining momentum.

2) The banks will report good numbers because they talk to Geithner EVERY DAY about how they are doing. He is protecting the $1 trillion we have given to banks and financial institutions and for his own sake, must know how the banks are faring. If they were in trouble, we would know about it already because nobody likes surprises.


3) Q2 earnings will be presented as improving month-to-month versus the less favorable Y-O-Y. You will be sold on how things are improving and to forget about t he Y-O-Y because it is not valid in this recession.


The market will meander until Q3 reports. In the mean time, get dividends while you wait for the market to move. Take advantage of this by getting into a strong position in some of the things that we CANNOT DO WITHOUT like:

OIL – BP (Yield = 7.43%), RDSB (Yield = 7.11%), etc.

UTILITIES - ATT (Yield = 7 %), VZ (Yield = 6.4%), VOD (Yield = 6.2%), NGG (Yield = 5.9%), CHL, etc.

FOOD - ADM (Yield = 2.1%), MOO (Total Return = 23.7%)

BANKS - NYB (Yield = 9.3%)

I hold positions in all of the mentioned stocks.

Good Luck.

Jul 13 06:28 AM

[gjc207:]

QUOTE: "2) The banks will report good numbers because they talk to Geithner EVERY DAY about how they are doing. He is protecting the $1 trillion we have given to banks and financial institutions and for his own sake, must know how the banks are faring. If they were in trouble, we would know about it already because nobody likes surprises."

Of course the banks will report good numbers. Again the govt allows the banks to value their own toxic waste. Mark to market is gone. Naturally reports will look good. But it doesn't mean there is anything except continued deception.

Jul 13 07:50 AM

[Mad Hedge F...:]

It's a definite possibility. I spent the evening with Dr. Janet Yellen, thepresident of the Federal Reserve Bank of San Francisco. She thinks thatthanks to the government’s tax cuts and spending programs, we will beout of the recession by the end of this year. After massive inventoryliquidation, the auto industry in particular is poised for a rebound.Financial markets are now in better condition than we imagined possiblesix months ago. However, the pace of the recovery will be frustratinglyslow, and it could take several years to return to full employment.Since the majority of the Fed board members feel that inflation will bestuck at 2% for years to come, deflation presents a greater risk thaninflation. We are not by any means out of the woods yet. Rising energyprices and interest rates are a potential drag on the economy.Commercial real estate is at the top of her worry list, as fallingrents and capital values could create a downward spiral, furtherimpairing the banks. China’s wishes for an alternate reserve currencyare impractical. Answering questions as only a UC Berkeley professorcan, she further confirmed my belief that we are looking at an “L”shaped recovery at best (see www.madhedgefundtrader... and www.madhedgefundtrader... .However, she did pour some cold water on my idea that the TBT hasfurther to run. “Inflation running up to untoward levels doesn’t makeany sense,” she averred.

Jul 13 09:07 AM

[TradingHelp...:]

Very interesting thank you. Is it possible that the US can stay in a deflationary environment when there is likely to be sustained upward pressure on commodities due to Asian growth.

GDP predictions for 2009: China 7.5%. India 5.4%. Middle East 2.0%. Also a likely return to 2.5% global growth in 2010. (IMF predictions).

How can the US suffer deflation in that environment? I am not questioning your obvious expertise, but there is a global economy to consider, not just a US one.

Jul 13 10:22 AM

[Dian L. Chu:]

There are indications that China may halt their stock piling on commodities as they are getting pricey. This will likely drive the commodity prices back down, as there are no visible demand recoveries anywhere else in the world. Of course, when the prices are low enough, China may start buying and prices would go up again. So, you might see this pattern repeating, but it is in no way a "sustained upward pressure".

The recent run-up in the commodities is mainly techinical and seasonal based, not on market fundamentals. China/BRIC and traders can not drive the commodities forever. The 2nd half is traditionally the weaker part of year for commodities. We are already seeing oil prices dropping back to $60/b, which is just one example.

In addition, much of the emerging economies' growth is still largely dependent upon developed countries like the U.S. If U.S., still the largest economy in the world, is not buying or investing as much due to factors outlined in my article, developing economies will likely be negatively impacted as well since it is a global economy.

Bottom line: There has to be a recovery from developed as well as developing countries to sustain a true global market recovery.



On Jul 13 10:22 AM TradingHelpDesk wrote:

> Very interesting thank you. Is it possible that the US can stay in
> a deflationary environment when there is likely to be sustained upward
> pressure on commodities due to Asian growth.
>
> GDP predictions for 2009: China 7.5%. India 5.4%. Middle East 2.0%.
> Also a likely return to 2.5% global growth in 2010. (IMF predictions).
>
>
> How can the US suffer deflation in that environment? I am not questioning
> your obvious expertise, but there is a global economy to consider,
> not just a US one.

Jul 13 10:49 AM

[enki09:]

I tend to agree with the stagnation scenario and the Author hits the underlying reasons. Not only are the baby Boomers past their spending peak they are now forced to virtually start over in building wealth lost to the stock market collapse.

In addition I think that we had essentially reached a condition of market saturation real estate. This was masked by the millions of loans to purchase and refinance that were being made to people normally outside the market (sub prime loans).

So now the era of unfettered consumerism is over (at least for the time being) as people try to regain their footing. These same people will remain wary for a while no matter how positive a picture that the government paints to try to stimulate spending (once bitten, twice shy).

That said, I think that basic necessities will continue to thrive and show modest growth through this period with regionally based business seeing the most growth.

Jul 13 12:06 PM

[Gregman2:]

Very good points. A key reason why Americans have not been saving is a decline in real earnings. And the ongoing debt deflation is likely to
play out as yellen says...be it 18, 24, or even 36 months. It's hard to say, but it's painful nevertheless.

Jul 13 12:46 PM

[Dian L. Chu:]

See this article on USA Today web stie: bit.ly/4dNKXF

Jul 14 12:42 AM