Deflation Risk Remains At Zero As Inflation Continues Its Gradual Acceleration

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by: Ed Dolan

Summary

Investors must weigh risks of both inflation and deflation as they look forward to the years of the Trump presidency.

TIPS prices can be used to forecast both deflation and inflation risks.

At the moment risks are asymmetrical, with inflation rising and deflation probabilities at or near zero but political developments could change the picture.

Investors must weigh not only the risk of inflation, but of deflation, too, as they look ahead to the probable path of the economy during the Trump presidency. In popular imagination, inflation may be more feared, but deflation can also be devastating, as the case of Japan has shown. As explained in this tutorial, deflation can damage an economy by undermining the solvency of the banking system, complicating the conduct of monetary policy and producing unrest in labor markets.

As measured by year-on-year change in the CPI, inflation, which has been moderate throughout the recovery, has begun to move up at bit. The year-on-year increase for January 2017 was the highest in five years, at 2.5 percent. A CPI inflation rate of 2.5 percent is roughly equivalent to the Fed's target inflation rate of 2 percent as measured by the personal consumption index. The latter, for technical reasons, tracks about half a percentage point lower than the CPI.

A swing to expansionary fiscal policy in the form of infrastructure spending, military spending or radical tax cuts is one event that could trigger a further rise in inflation. So could an easing of monetary policy as might happen if President Donald Trump were to appoint determined doves to the open seats on the Federal Reserve Board.

Developments that could trigger deflation receive less prominence but are not beyond the realm of possibility. One would be a decisive victory by Republican budget hawks in the coming fiscal policy debates. Another would be the appointment of monetary hawks to the Fed - no one seems to be entirely sure which way the president leans on this. Finally, many economists think that a move toward protectionism in trade, possibly in the form of some kind of border tax, would produce downward pressure on the price level by boosting the exchange rate of the dollar.

Most investors know that the market for Treasury Inflation Protected Securities, or TIPS, can be used to forecast future inflation. The Cleveland Fed regularly publishes estimates of inflation expectations based on TIPS prices. Less well known is the fact that TIPS prices also can be used to make deflation forecasts. The forecasting method relies on the fact that TIPS with different issue dates but the same maturity date offer slightly different degrees of protection against deflation. The Atlanta Fed, which publishes regular estimates of the probability of deflation, based on TIPS prices, explains the method in these terms:

Here's the idea: A TIPS cannot pay less than its face value at maturity, so the principal repayment of a five-year TIPS issued today is not reduced if the five-year rate of inflation is negative over the life of the security. But a 10-year TIPS issued five years ago will have its capital gain from accrued inflation reduced if there is a net decline in the CPI over the next five years. As a result, part of the real yield spread between the 10-year and five-year TIPS issues should reflect the value of the better deflation safeguard of the latter security.

A technical note explains the mathematics of the estimation method in more detail. The Atlanta Fed expresses its estimates of deflation risk as the probability that the CPI at the end of a given five-year period will be lower than the CPI at the beginning of the period. Different cohorts of TIPS securities produce the estimates for each year. For example, the estimated probability of deflation over the interval 2016 to 2021 is derived from the prices of five-year and 10-year TIPS, both with maturity dates in 2021.

The following chart shows that deflation probability based on all maturities has fallen to zero since January 12 of this year. Before that, the probability of deflation had been continuously positive since August 24, 2015.

At the moment, then, inflation/deflation probabilities are asymmetrical. The risk of inflation appears to be significantly higher than that of deflation, at least as measured by TIPS-based methods. However, investors should remember that the data shown in these charts are based on past observations of the market prices of goods, services and securities. The actual future risks of both inflation and deflation, however, depend as much on political developments as on purely economic ones. Given the uncertainties of today's political environment, it would be imprudent to say that the risk of deflation is in fact zero, in the broader political sense rather than the narrower mathematical one.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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