Is Deflation On The Horizon?

| About: ProShares Inflation (RINF)

Summary

The Federal Reserve is still discussing the timing of the second interest rate hike.

If they decide to hike, it would pose a problem to achieving their dual mandate because it could strengthen the dollar.

A strong dollar creates deflationary pressure due to the impact on import prices.

With the Federal Reserve discussing the second interest rate hike in under a year, this would be a good time to start discussing the risk of deflation. When the Federal Reserve is measuring the growth of the economy, one of the things they're looking for is a 2% annualized inflation rate. However, the strength of the dollar over the last 2 years represents a challenge to fulfilling the inflation objective. The following chart provides a clear indication of the strength of the dollar over the last 5-year period:

Click to enlarge

Source: Bloomberg

Federal Reserve's Analysis

The Wall Street Journal published an article on the impact of a strong dollar in March of 2015.

In that article, the WSJ attributed the recent rise in the dollar to international expectations for the short-term rates in the United States to increase. Specifically, they stated:

"The U.S. dollar has been rallying sharply against major currencies around the world, in part because of the prospect that the Fed will begin to tighten credit in the U.S. this year at the same time central banks around the world are cutting interest rates or pursuing other types of aggressive stimulus policies."

At that point, the Cleveland Federal Reserve indicated the impact of a strong dollar should be fairly minor. According to their work, the expected impact over 6 months from a 1% increase in the value of the dollar against other currencies was about a .3% decrease in import prices excluding petroleum products.

That doesn't sound like a big deal. How big of an impact can we really expect .3% to be? The real challenge here is that the strength of the dollar did not just rally by 1%. Around the start of July 2014, the dollar Index was approximately 80. As it stands the dollar Index has run between about 99.6 and 93.1 so far in 2016. On average, the strength of the dollar is off about 18 to 19% since the middle of 2014. If we applied the same formula to the cumulative increase in the strength of the dollar we have seen so far, it would suggest of cumulative deflationary impact on import prices of around 5.6%. Consider the potential for a 5.6% deflationary pressure in the span of about 2 years. Losing 5.6% over two years would suggest about a 2.8% annual deflationary rate on import prices. If domestic prices were pushed down by international competition, it would keep a lid on prices. It should be enough to make it extremely difficult for the Federal Reserve to achieve a 2% inflationary target. One example of an area where inflation targets are hitting above the expected level is increases in apartment rent.

Unlike most commodities, apartments cannot be imported. The raw materials used to build apartments can be imported to a degree; however, there are fairly substantial costs with transporting some of those imports. Further some of the raw materials that would be imported are already priced in US dollars on the international markets. For example, copper prices are already set in US dollars. The inability to rapidly expand the housing stock combined with low mortgage rates leads to higher prices and higher rents.

Another challenge with the deflationary impact of lower import prices is the future impact on employment rates. While the unemployment rate is under 5%, the percentage of the population included in the labor force lingers at exceptionally low levels. These low levels of employment relating to the total population provide a headwind for GDP growth. Rapid GDP growth comes from high employment and high productivity from each employee on average. Therefore, the strong dollar is a challenge to the growth of the American economy.

Market Expectations

The strength of the dollar has been heavily influenced by market expectations about future interest rates. If the Federal Reserve decides to raise rates again, it will create an even larger disconnect in the short-term rates available to US banks compared to the short-term rates available to banks in other countries. If this causes US banks to sell off more of their short duration treasury portfolios in favor of holding cash and collecting interest on excess reserves, that creates an opportunity for the international banks to buy short duration treasuries so they can remove the cash from their balance sheets and avoid the negative rates imposed by the European Central Bank. The international demand for short duration treasuries could drive the dollar higher.

If the goal of the Federal Reserve is 2% inflation and high enough employment to support GDP growth, then trying to push domestic bond yields higher is the wrong solution. Theoretically, under efficient markets, a 1% increase in the value of the dollar would suggest roughly a 1% decrease in the cost of imports. Even though the expected impact is only .3%, it should give the Federal Reserve pause when they consider jacking up short-term rates. Let us all hope sanity prevails.

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