Tuesday, October 1, 2013

Should We Be Worried About Deflation?


Higher interest rates.

Virtually every strategist I read, every meeting I attend - the assumption that interest rates will be headed higher is almost universally held.

There are many reasons for this widely-held belief, including the eventual "taper" of Fed activity in the credit markets.

However, most also assume that inflation will be headed higher than today's rates, which will cause bond investors to demand higher yields.

Problem is, inflation is nowhere to be seen.  If anything, inflation rates are pointed lower, not higher, as University of Michigan economist Justin Wolfers wrote in a column for Bloomberg on September 26.

Here's an excerpt:

...there's one number that caught my attention. The Bureau of Economic Analysis has revised its estimates for the personal consumption expenditures price index. It's an important number, because this is the index the Federal Reserve targets. And remember, it's aiming for inflation of 2 percent.

Instead, the index fell in the second quarter. That is, the U.S. is experiencing deflation.

I won't overstate this. It's just one quarter, and it's evident in just one index, and even when I cherry-pick this interesting number, prices aren't really falling very quickly. The PCE deflator fell at an annual rate of only 0.1 percent in the second quarter.

But it's striking that the Fed's preferred price measure is declining at a time when the main conversation among policy makers is when and how to tighten monetary policy, rather than to make it more accommodative....

Right now, the risk of deflation is greater than the risk of explosive inflation.


The chart above illustrates Wolfers's point.  If you look at the inflation figures on the right hand side of the chart, you can see inflation is barely above 1% whether you include food and energy price changes (which tend to be more volatile) or not.

Writing in the New York Times on October 1, investment manager Daniel Alpert thinks that deflationary pressures loom due to an oversupply of, well,  just about everything:

...We are in an age of global oversupply: an oversupply of global labor (hence high underemployment); an oversupply of global productive capacity (hence ultra-low inflation); and an oversupply of global capital (hence low interest rates). 

This explains why, around the middle of each of the past three years, activity petered out after predictions earlier in the year that the economy would finally achieve escape velocity. 

The jobs created have been mainly low wage and part time. Growth in domestic manufacturing is still slow, and business spending has fallen, though corporations are flush with profits. Debt-saddled households continue to see real incomes deteriorate (even with very low inflation). Sales of new homes have suddenly reversed course. Rents are falling in several markets where home prices have recently increased. Even the seemingly unflappable stock market has been seesawing because of the uncertain economic signals. 

Now, I find myself uneasily with the majority opinion, that inflation rates (and interest rates) will soon begin to rise as the economy improves.

But it seems to be a useful exercise to at least consider the economic and investment implications of a world where prices stay stable or move lower in the months ahead.