Christine Lagarde, the managing director of the International Monetary Fund (IMF), has warned the world of the growing threat of deflation. Or, as she more poetically put it, deflation is the "ogre that must be fought" by the developed countries of the world. The picture she drew was that of Japan over the past 20 years.
The question I raise today is, how credible is this concern over possible world deflation? To begin this discussion I turn to the situation in Japan.
Japanese Prime Minister Shinzo Abe has staked his government's credibility on the country recovering from its economic malaise. This week at Davos "he declared that his country was about to 'break free' from about 15 years of deflation."
What evidence might be obtained in the market to indicate that people believe that Mr. Abe and the Japanese government might be successful in accomplishing this goal?
One place to look is in the financial markets. The general idea here is that "nominal" interest rates are a combination of the real rate of interest in a country and what investors believe to be the expected inflation in that country. Economists argue that a country's real rate of interest should approximate the expected real rate of growth of the economy.
The 10-year bond of the Japanese government is currently trading to provide an investor a "nominal" yield around 0.65 percent. Thus, if the expected real growth of the Japanese economy over the next ten years is, say, 2.00 percent, then the market expectations for inflation over the next ten years is a negative 1.35 percent.
In other words, investors in the sovereign debt of Japan expect that prices will decline over the next ten years at a rate of 1.35 percent per year.
Apparently, the optimism being expressed by Prime Minister Abe has not yet reached the part of the investment community that invests in Japanese sovereign debt. And, this conforms to Ms. Lagarde's picture. But, what about inflationary expectations in the United States?
Well, Gene Epstein, who writes the "Economic Beat" column in Barron's, titled his piece in the January 17 issue of Barron's "More Disinflation Lies Ahead." Now, deflation is an absolute decline in the price level. Disinflation is a situation in which inflation still exists but the rate of inflation is declining over time.
Mr. Epstein writes that in the United States "the 2013 December-to-December increase of 1.5 percent (in the CPI) was down from a 1.7 percent increase in 2012….And both of the past two years' increase were much lower than the 2.4 percent average annual rise over the past 10 years."
The forecast given by Mr. Epstein is for the rate of change in the US price level to continue to decline in the near future.
But, let's see what the US financial markets might be saying to see if they conform to Mr. Epstein's analysis. We will do this in the same way we looked at the Japanese situation.
Currently, the yield on the 10-year Treasury bond is around the 2.80 percent level. Let's be conservative and say that the expected real growth rate for the U.S. economy over the next ten years is a modest 2.5 percent per year.
If this is the case, the market is expecting prices to rise at a compound rate of 0.30 percent over the next ten years. In order to achieve this compound rate of growth the annual rate of inflation in the United States over the next two years or so would certainly have to fall from the 1.5 percent level it achieved in 2013.
But, there is another way to look at the inflationary expectations that are built into market interest rates.
The yield on the Treasury Inflation Protected securities (TIPS) can be looked at as a market proxy for the real rate of interest. On Thursday morning, January 23, the 10-year TIPS was trading to yield just under 60 basis points. If one subtracts this real rate of interest from the current nominal yield one comes up with an estimate for the market's expectation of inflation and that estimate would be 2.3 percent.
If expected inflation is 2.3 percent per year for the next ten years then the conclusion that one can draw from the market is that inflation is going to rise and will, in the future, accelerate to higher rates of inflation given that the rate of inflation in 2013 was 1.5 percent.
So, we have two projections of the future rates of inflation in the United States, one that projects the rate of inflation to decline over the next ten years, and, one that projects the rate of inflation to rise. Which one is correct?
I have argued for the past year or so that the yield on TIPS is lower than it should be. The yield on the TIPS is a proxy for the expected real rate of growth of the economy. I believe that the current market rate of 0.60 percent is substantially below the expected real rate of growth of the US economy for two reasons. First, this low rate has been achieved by the huge flow of funds over the past several years from Europe as the financial distress being felt there caused risk averse investors to seek a "safe haven" in US Treasury securities. The rise in this yield from the levels it had reached into early 2013 was a result of this flow of funds.
A second reason is that the massive amount of liquidity in US financial markets resulting from the Federal Reserve's policy of quantitative easing has caused the yield on the 10-year TIPS to fall substantially below a reasonable estimate for the expected rate of growth of the economy. Which one of these reasons dominates is anyone's guess. I tend to think that the first one has been dominant.
An interesting fact, however, is that the yields on the 10-year TIPS and the regular 10-year Treasury has moved in an almost parallel fashion over the past several years. This would indicate that the expected inflationary expectations built into the difference between these two yields have been relatively stable.
For example, during the latter part of 2012 and the first half of 2013, inflationary expectations measured in this way averaged around 2.5 percent. In the latter half of 2013, as mentioned above, inflationary expectations have averaged around 2.3 percent.
If this is the measure of inflationary expectations we use, then disinflation has impacted the market's anticipations. In other words, price disinflation may continue for the near term, but inflation will pick up in the longer term and rise above the 2.3 percent level.
This interpretation can be expanded to present a picture of future U.S. inflation where there will be a continued fall in the rate of inflation in the next year or two as economic growth remains modest, but after that the rate of inflation will increase as the Fed's massive injection of reserves into the banking system actually impacts the economy and results in faster and faster rates of inflation. This scenario, to me, seems more realistic than Ms. Lagarde's picture of price deflation taking over. It, however, does not explain the situation in Japan.