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Some Lessons from The Great Inflation and Disinflation Peter Hooper Chief Economist Deutsche Bank Securities [email protected] 1 212 250-7352 Torsten Slok Senior Economist Deutsche Bank Securities [email protected] 1 212 250-2155 DISCLAIMER AND ANALYST CERTIFICATION ARE LOCATED ON THE LAST PAGE Outline • Quantifying trends and volatilities of inflation. • Implications of inflation stabilization. • Causes of the great inflation and disinflation. • Could it happen again, and if so, why? 2 Inflation a little high for comfort recently yoy% 3.0 yoy% 3.0 Consumer prices (PCE) ex food and energy 2.5 2.5 2.0 2.0 Fed’s Comfort zone 1.5 1.5 1.0 1.0 0.5 1996 0.5 1998 2000 2003 2005 Source: BEA,DB Global Markets Research 3 But its been a lot higher… yoy% yoy% Consumer prices (PCE) ex food and energy 12 12 11 11 10 10 9 9 8 8 7 7 6 6 5 5 4 4 3 3 2 2 1 1 0 0 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 Source:BEA, DB Global Markets Research 4 Inflation trend has fallen dramatically since early 80s % 12 PCE ex food and energy (Q/Q, AR) 10 % 12 10 Trend 8 8 6 6 4 4 2 2 0 1965 0 1970 1975 1980 1985 1990 1995 2000 2005 Source:BEA, DB Global Markets Research 5 Volatility of inflation has plunged too % % 1.4 1.4 1.2 1.2 1.0 Standard deviation of change in inflation trend 1.0 0.8 0.8 0.6 0.6 0.4 0.4 0.2 0.2 0.0 0.0 1965 1970 1975 1980 1985 1990 1995 2000 2005 Source: BEA,DB Global Markets Research 6 Inflation trends have fallen globally 25 25 Inflation trends Germany Japan United States United Kingdom 20 15 20 15 10 10 5 5 0 0 -5 1970 -5 1975 1980 1985 1990 1995 2000 2005 Source: DB Global Markets Research 7 Inflation volatilities have plunged globally too 4.0 Standard deviation of change in inflation trend 3.5 3.5 Germany Japan United States United Kingdom 3.0 2.5 2.0 4.0 3.0 2.5 2.0 1.5 1.5 1.0 1.0 0.5 0.5 0.0 0.0 -0.5 1970 -0.5 1975 1980 1985 1990 1995 2000 2005 Source: DB Global Markets Research 8 Why does lower inflation and especially lower volatility of inflation matter? • Anchoring of expectations • Inflation risk premium and real interest rates 9 Inflation expectations anchored at low level 10 % 9 8 7 FRBUS inflation expectations % 10 Philly Fed inflation expectations 9 8 U.Mich 5-10yr inflation expectations 7 6 6 5 5 4 4 3 3 2 2 1 1 0 1965 1970 0 1975 1980 1985 1990 1995 2000 2005 Source: DB Global Markets Research 10 Real interest rates have trended lower 8 US 10yr Treasury yield-SCF inflation expectation % US 10 yr Treasury yield-FRB inflation expectation 9 UK inflation-adjusted 10 yr yield 8 US 10yr TIPS yield 7 7 6 6 5 5 4 4 3 3 2 2 1 1 0 1980 0 % 9 1985 1990 1995 2000 2005 Source: BEA,,FRB,DB Global Markets Research 11 Result: Rising asset values, falling saving rate % 7 ratio Personal saving rate 6 14.0 12.0 10.0 8.0 6 6.0 4.0 5 2.0 0.0 5 Household Wealth, ratio to to income 4 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 -2.0 -4.0 Source: BEA, FRB, DB Global Markets Research 12 What caused the great inflation and disinflation? • Accommodative monetary policy in the face of inflationary demand and supply shocks • Monetary tightening and behavior consistent with a rules based policy 13 Monetary policy consistency 30 % Deviations from Taylor Rule 25 % 25 United States Germany United Kingdom Japan 20 15 30 20 15 10 10 5 5 0 0 -5 -5 -10 1970 -10 1975 1980 1985 1990 1995 2000 2005 Source: DB Global Markets Research 14 Trend core PCE inflation and policy rate deviations from Taylor rule % Deviation from Taylor rule(output gap) Deviation from Taylor rule(real time output gap, H-P based) % Deviation from Taylor rule(Orphanides' real time output gap) 12 Trend in core PCE (rs) 12 10 8 6 4 2 0 -2 -4 -6 -8 -10 1965 1970 1975 1980 1985 1990 1995 2000 2005 10 8 6 4 2 0 -2 -4 -6 -8 -10 Source: BEA ,DB Global Markets Research 15 Output gap measures % 8 Output gap,Current Data Output gap,H-P filtered real time Output gap,Orphanides real time % 8 4 4 0 0 -4 -4 -8 -8 -12 -12 -16 -16 1965 1970 1975 1980 1985 1990 1995 2000 2005 Note: Measures the percentage deviation of actual from various measures of potential output. . Source: CBO, Phil fed, Orphanides (2003),DB Global Markets Research 16 What could cause inflation trend and volatility to rise again? • Politics • Demographics • Global factors 17 Politics Barney Frank January 2007: • Fed policy is fair game again in Congress • No inflation targeting on my watch. • Fed needs to hold interest rates down to allow wages to rise. Source :DB Global Markets Research 18 Inflation: a Political Influence (PCE less food and energy) yoy% yoy% 12 12 Wright Barney 11 11 Patman Frank Era 10 10 9 9 8 8 7 7 6 6 5 5 4 4 3 3 2 2 1 1 0 0 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 Source:BEA, DB Global Markets Research 19 Politics contd. • Fed and markets have learned a lot over the past four decades. • Has gotten Frank to acknowledge that its real wages that matter, not nominal wages. • May settle for something less than formal inflation target. Source :DB Global Markets Research 20 Implications of ageing boomers: • Slower growth of labor force and potential output • Massive increase in social security and health care costs • Higher interest rates 21 Demographics: Ageing Baby Boomers 25 % of population 1910 1920 1930 1950 1960 1970 1980 1990 2000 2010 1940 2020 2030 2040 2050 projection % of population 25 20 20 20 20 15 15 15 15 10 10 10 10 5 5 5 5 0 0 0 0 0-9 0-9 10-19 20-29 30-39 40-49 50-59 60-69 70-79 80-89 10-19 20-29 30-39 40-49Age50-59 60-69 70-79 80-89 Age 90+ 90+ Source: Census, DB US Economics Research 22 Labor force growth set to drop Percent 100 Labor force participation rates: 2006 Percent 100 Male Female 90 90 80 80 70 70 60 60 50 50 40 40 30 30 20 20 10 10 0 0 16-19 20-24 25-34 35-44 Age 45-54 55-64 65+ Source: BLS, DB US Economics Research 23 Dependency ratio age on verge of jumping % 50 Population age 65+ as a percentage of the population age 20-64 45 40 % 50 45 Projection 40 35 35 30 30 25 25 20 20 15 15 10 10 5 5 0 0 1960 1970 1980 1990 2000 2010 2020 2030 2040 2050 2060 Source: Social Security Administration, DB US Economics Research 24 Social Security spending nearing take-off % of GDP 7 % of GDP Social Security spending projections 7 6 6 5 5 4 4 3 3 2 2 1 1 0 0 1962 1970 1978 1986 1994 2002 2010 2018 2026 2034 2042 2050 Source: CBO, DB US Economics Research 25 Medical spending set to blast off % of GDP 25 20 Medicare and Medicaid Medicare/Medicaid spending projections % of GDP Assumes medical inflation 25 20 4-1/2% 15 15 3% 10 10 5 5 Social Security 0 0 1962 1970 1978 1986 1994 2002 2010 2018 2026 2034 2042 2050 Source: CBO, DB US Economics Research 26 Global factors could cause inflation trend and volatility to rise again 27 Global Dimension: Growing Imbalances bn $ 400 200 bn $ 400 Middle East China 200 Canada 0 -200 Other/ stat discrep ancy Japan Other Asia Western Africa Hemisphere EU US India 0 Aus/NZ -200 -400 -400 -600 -600 -800 Current account in 2005 Source: IMF, DB Global Markets Research -800 28 US Net External Debt Growing Rapidly Bil$ 1000 Net international investment position of the US 500 Bil$ 1000 500 0 0 -500 -500 -1000 -1000 -1500 -1500 -2000 -2000 -2500 -2500 -3000 -3000 1975 1979 1983 1987 1991 1995 1999 2003 Source:BEA, DB Global Markets Research 29 China’s reserves soaring Billion $ 1200 1000 Billion $ 1200 1000 China's official foreign exchange reserves 800 800 600 600 400 400 200 200 0 1999 0 2001 2003 2005 Source: PBC, SAFE, DB Global Markets Research 30 China’s inflation edging up yoy % 6 yoy % 6 China cost of living index 4 4 2 2 0 0 -2 -2 -4 1998 -4 2000 2002 2004 2006 Source: CNBS, DB Global Markets Research 31 China asset markets: looking bubbly yoy% 140 120 100 yoy% 12.5 Shanghai stock price index (ls) 10.0 China house price index (rs) 80 7.5 60 5.0 40 20 2.5 0 0.0 -20 -40 1998 -2.5 2000 2002 2004 2006 Source: CNBS, Shanghai stock exchange, DB Global Markets Research 32 China moving toward currency flexibility Yuan/US$ 8.3 8.2 % Yuan/US$ exchange rate 2 Level (ls) 13wk % change ar (rs) 0 8.1 -2 8.0 -4 7.9 -6 7.8 -8 7.7 2005 -10 2006 2007 Source: FRB, DB Global Markets Research 33 China/Asia restraining US inflation YoY% 3 2 1 Average inflation ,1996-2006 PCE ex food and energy YoY% 3 Prices of US imports from emerging Asia US total non-oil import prices 2 1 0 0 -1 -1 -2 -2 -3 -3 Source :Haver, DB Global Markets Research 34 But the restraint is small and diminishing YoY% 0.0 YoY% 0.0 -0.1 -0.1 -0.2 -0.2 -0.3 -0.3 Estimated impact of Emerging Asia on US Core PCE inflation -0.4 -0.4 -0.5 -0.5 -0.6 1996 -0.6 1997 1999 2000 2002 2003 2005 2006 Source :Haver, DB Global Markets Research 35 Wrap-up • Inflation and disinflation are monetary phenomena • Inflation trend and volatility are near a low point. • Longer-term risks to inflation and rates, largely to upside, include political, demographic, and global forces. • Low and stable inflation expectations do not afford complacency at the Fed. 36 Torsten Slok, Ph.D. Director/Senior Economist, US Economics Deutsche Bank Securities, Inc. Torsten Slok joined Deutsche Bank Securities in the fall of 2005 and is a senior member of the US Economics Team. Prior to joining the firm, Dr. Slok worked at the OECD in Paris in the Money and Finance Division and the Structural Policy Analysis Division. Before joining the OECD he worked for four years at the IMF in the Division responsible for writing the World Economic Outlook and the Division responsible for China, Hong Kong and Mongolia. Dr. Slok studied at Princeton University and University of Copenhagen. He has published numerous journal articles and reviews on economics and policy analysis. 37 Analyst Certification The views expressed in this report accurately reflect the personal views of the undersigned lead analyst(s). In addition, the undersigned lead analyst(s) has not and will not receive any compensation for providing a specific recommendation or view in this report. 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