November, 2013

Teetering on the edge: will America plunge into deflation?

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Teetering on the edge: will America plunge into deflation?

There is no prize for identifying that the American economy is in a difficult position. After five years of aggressive quantative easing and near zero interest rates the economy remains mired with persistent levels of unemployment, low growth and low inflation. This is all to the frustration of outgoing Chairman of the Federal Reserve Ben Bernanke. It is little wonder that he is leaving.

Today we will look at the latest data about inflation, the concerns about disinflation and try and determine the potential course of action out of this mess. Does it all rest on newly appointed Janet Yellen’s shoulders?

Disinflation

The US is currently experiencing low inflation rates. Like most advanced economies the Fed attempts to keep inflation within a band of 2-3%. From July to September this year the rate fell from 2.0% to 1.2%. This has people in and outside the Fed concerned about the possibility of disinflation tumbling into deflation.

It is clear from the graph below that there has been a decline in inflation rates in the US since 2011. Certainly, this decline pales in comparison with the rate of 2008.  However there is a qualitative difference between 2008 and now. We can understand the severe decline in 2008 to be an immediate consequence of the financial crash, with markets and investors incredibly shaken or insolvent.

Teetering on the edge1

Since the crash the Fed has maintained near zero interest rates and has flooded the market with liquidity through its US$85bn per month program of quantative easing. This program was introduced to ensure the money supply remained buoyant during the immediate aftermath of the crash, in an attempt to boost the economy. It was a necessary alternate policy option for the Fed because monetary policy had not initiated the sorts of change in investment and consumption patterns that the economy required to grow.

Initially there were fears that such an aggressive program would encourage inflationary pressures because it is effectively printing money at a rate disconnected to demand and capacity within the economy.

After three rounds of the program, interestingly or shockingly what we are seeing is clear evidence against this orthodox view.

Disinflation is emerging despite the policy of quantative easing. This is to say that despite the fact that there is more money in the economy it is not having an impact on prices as shown in the inflation graph above and certainly it has not had a substantive impact on employment.

While the graph below indicates a tapered decrease in unemployment from 10% in mid 2009, the September rate of 7.2% remains well above the ‘natural rate’ of unemployment shown in the second graph.

Teetering on the edge2

Teetering on the edge3

Surprisingly however the most recent ISM index (which measures the activity in manufacturing in the States) unexpectedly increased. The index increased from 56.2 in September to 56.40 in October. This is certainly not the leaps and bounds wanted, but commentators have responded positively to the news. The graph below shows the change in activity over 2013.

Teetering on the edge4

However this good news needs to be qualified. Manufacturing represents only 12% of GDP in the American economy. Accordingly, even if it does continue to experience increases in activity it is unlikely to have an impact on jobs, or inflation. To overcome this disinflationary trajectory investment is necessary in job producing industries.

But herein lies the rub. Investment is not occurring precisely because of disinflation. Bernanke recognized this when he said that low inflation could cause the ‘recovery’ to bog down by inhibiting capital investment and increasing the risk of ‘outright deflation’. However he suggested that the slowdown in inflation was a reflection of ‘some factors that are likely to be transitory.’

It would seem Bernanke is still holding his breath that the Fed’s stimulus will eventually seep into other sectors of the economy and thus miraculously lead into growth and stable inflation.

The global financial experiment therefore continues.

The fear of the lost decade

Why is it that economists are so nervous about the prospects of deflation?

We need only look at the experience of Japan in the 1990’s to answer this. After an asset price boom in the 1980’s, which saw people and businesses taking on debt, Japan suffered a long and protracted deflationary period. Despite active efforts by the central bank, they were unable to reverse the downward spiral in prices and endured a ‘lost decade’ as a consequence. Decreases in prices don’t seem like a problem until debt, fixed in nominal terms, is considered. The consequence of decreasing prices is an increase in the burden of paying debt off. Contractions in consumption and investment must then follow which further perpetuate the problem.

As shown in the graph below, Japan experienced declining prices during the mid 1990’s to mid 2000’s. The black line indicates the GDP deflator index, the red line indicates CPI and the green line shows the domestic corporate goods price index (DCGPI), which measures the price developments of goods bought by companies. The DCGPI is of particular significance because it indicates negative price variation in the private sector for a decade. This inevitably impacts on consumer products and growth and thus compounds the deflationary spiral. While there was some increase in the second half of the decade, it is evident that Japan has still not come out of the woods.

Teetering on the edge5

In the US context, the issue is debt.

The US government, households and businesses are heavily indebted. This is widely known. Three decades of falling interest rates, asset price bubbles and a desire to consume today rather than tomorrow, has contributed to this indebtedness.

The figure below shows the debt to income ratio of households. This ratio has consistently increased over the long term and only since the crash of 2008 has it begun to decline. Despite this decline household indebtedness remains at a historic high of 110%. In nominal terms, household debt sits at $11.15 trillion. The portion of disposable income spent on servicing this debt has decreased from 2007, but remains high at 10.5%.

Household debt to income ratio

Teetering on the edge6

The debt to GDP ratio of the US government is also significant. The graph below shows the massive increase in government indebtedness since Reagan’s election in 1981. A significant component of the debt increase since 2007-2008 has been the $787 billion bailout package. Currently debt to GDP sits just over 100%.

Teetering on the edge7

As of September 30 the US federal governments total debt stood at $16.74 trillion. Net interest payments on the total government debt totaled $222.75 billion, or 6.23% of all federal outlays.  To put this in context, it is close to half what the US government spends on social security.

It is important to remember that US interest rates are and have been historically low for a long time. If the disinflation experienced at the moment were to tumble into deflation, these servicing requirements would increase despite the fact that interest rates would remain low.

If deflation does occur in the US it would unfold in a similar way to Japan. In an effort to repay increasing debts people would limit consumption and investment, which would have downward pressure on wages and employment and cause a negative downward and self-reinforcing cycle.

With interest rates already near zero, and quantative easing flooded the market with money, the Fed would effectively become impotent.

Conclusion

Despite the best efforts of the Federal Reserve, the US economy is still struggling to lift itself up after 5 years of economic pain.  Chairman Bernanke slatted in previous months the possibility of tapering the enormous quantative easing program, however considering the above data, the possibility of this actually happening any time soon seems optimistic. No doubt the Fed is acutely aware of the Japanese deflationary experience since the 1990s, and will be very keen to avoid a similarly lost decade (and counting) for the US.  Although it is too early to make a definitive call, it appears that current monetary policies being adopted for this aim are having very limited, if any, success.