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Deflation August 26, 2010 Q&A on causes, remedies and market implications In the past two years, inflation in both the US and the eurozone (not taking into account energy-related fluctuations) has been on a downward trend. Core inflation in both economies has eased to multidecade lows of about 1%. This is getting dangerously close to zero. In combination with the continuing concerns about the economic outlook this has raised concerns about deflation. With bond yields for the core markets diving to astonishing lows bond markets are clearly taking the risk of outright deflation seriously. Bond markets looking at ultra-low yields (interest rate on 10-year bonds) 16 14 12 10 8 6 4 2 0 Jan-57 Jan-62 Jan-67 Jan-72 Jan-77 Jan-82 Jan-87 Jan-92 Jan-97 Jan-02 Jan-07 US Germany Japan Q. What is deflation? A. A fall in the general price level, but harmful deflation is about more than that Technically, deflation is defined as a decline in the general price level. However, not all forms of deflation are created equal. As illustrated in 2009, total inflation can be pushed below zero because of large fluctuations in commodity prices. The yoyo-move in oil prices through 2008 (up to 145 USD per barrel by mid-year, back down to 35 USD by year-end) pushed headline inflation below zero for most of 2009. But moves like this are usually just a temporary effect and not really relevant. Sharp increases in productivity can also lead to a decline in prices, but this would be accompanied by strong activity growth. Harmful deflation, the one that was seen in the 30s in the US and in Japan for the past decade and the one everybody should be worried about, is about more than just falling prices. Harmful deflation is a situation of declining demand, falling prices, falling incomes, rising debt burdens, …, in which all these elements reinforce each other. A predicament that is very hard to escape from. Core inflation dangerously low 3.0 2.5 2.0 1.5 1.0 0.5 0.0 Mar-97 Mar-99 Mar-01 Mar-03 US Mar-05 Mar-07 Mar-09 Eurozone Q. What causes harmful deflation? A. Insufficient demand Theoretically, deflation can be caused by central bank stupidity. If a central bank reduces the money supply too much, this would lead to deflation. However, the appropriate policy reaction would then be extremely straightforward: increase the money supply again. The roots of truly harmful deflation lie in a lack of demand. The dynamics run as follows: insufficient demand hurts the labour market, pushing up unemployment rates. This puts downward pressure on wages and hence on prices. Downward pressure on incomes and especially higher job insecurity will result in households increasing cautionary saving and reducing spending. Moreover, downward pressure on incomes increases the real burden of debt (income, which determines the debt repayment capacity, declines, while nominal debt levels remain unchanged). This leads to a rising number of defaults, which spell trouble for the financial sector and result in reduced credit growth. In turn these effects will bring down demand even further, and so on into a deflationary downward spiral. Q. What’s the problem with deflation? A. The debt-deflation spiral The main problem with harmful deflation is that it erodes the debt repayment capacity in the economy, while nominal debt levels remain unchanged. As such, deflation blows up the real debt burden with obvious consequences for the number of defaults and the financial sector. This issue was painfully illustrated in the US in the 30s. Between 1929 and 1933 the total level of debt in the US economy exploded from 133.5% of GDP to 213.5%. This was entirely caused by the fall in nominal GDP, as in the same period nominal debt levels were actually reduced from 142 to 122.4 bn USD. So even as the entire economy cut back on spending to reduce debt, the real debt burden exploded. Because everybody simultaneously tried to pay down debt, total activity declined faster than the debt reduction. The total debt level in the US economy today is 342% of GDP. Against this backdrop the onset of actual deflation would be disastrous. A debt-deflation spiral would be very hard to break. Deadly debt levels 380 330 280 Deflation 230 180 130 80 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 Total debt in the US economy (% of GDP) Q. What are the policy options to fight deflation? A. Extremely non-conventional policy should be able to tackle deflation As the root cause of deflation is a lack of demand, the appropriate policy response is obviously to push up demand. However, in a deflationary context conventional monetary policy breaks down. The central bank can lower its policy rate to 0%. However, the relevant interest rate for the economy is the real rate. When inflation is negative, even with the nominal interest rate at 0%, the real interest rate will be positive to the extent of the deflation and there is nothing the central bank can do about that. Nevertheless, even at the zero bound the central bank still has options. These were highlighted by current Fed-chairman Ben Bernanke in a 2002 speech ‘Deflation: Making sure ‘it’ doesn’t happen here’. The main line of that speech was ‘under a paper-money system, a determined government can always generate higher spending and hence positive inflation’. Options when the fed funds rate is at zero: • • • • Lowering rates on government bonds of longer maturity by o Committing to holding the overnight rate at zero for a specified period o Announcing explicit ceilings for yields, which could be enforced by committing to make unlimited purchases at those yields Influence directly the yields on privately issued securities Buy foreign government debt Money-financed tax cut or public spending, aka the ‘helicopter drop’ (this would require cooperation between the Fed and the Treasury) The Fed has already tried the first two options and is probably looking to go further down that line shortly. However, it is unclear how much pushing down interest rates any further from already very low levels can do for the economy. In any case, the nuclear option is still open: printing money and giving it to the government to finance direct spending. Such a move would be certain to generate economic activity. If pushed far enough, this would certainly tackle deflation. However, at the same time it would open an entirely new can of worms and almost certainly generate substantial turmoil in worldwide financial markets. Moreover, managing the exit strategy from such a policy would be quite a challenge later on (to put it mildly). Q. Are the US or Europe heading for deflation? A. Still not the most likely scenario, but especially in Europe risks are getting worryingly high Both in the US and in Europe core inflation has fallen to dangerously low levels. Moreover, there is still a lot of slack in both economies as illustrated by the significant outputgaps, subpar capacity utilization and high unemployment. This is bound to put further downward pressure on inflation. Against the backdrop of a very weak growth outlook (with downward risks) deflation has become a significant risk. Extensive slack in the economy to put further downward pressure on inflation 5 3 4 4 5 3 6 2 7 8 1 9 0 -1 Aug-86 10 Aug-90 Aug-94 Aug-98 US Average hourly earnings (lhs) Aug-02 Aug-06 11 Aug-10 US Unemployment rate (rhs, inverted) However, at the moment income growth in both regions is clearly positive and this looks set to continue (albeit at quite modest levels). This should prevent the onset of outright deflation. Moreover, as Bernanke is an expert on deflation, it looks likely that the Fed will do whatever it takes to avoid such a scenario. In spite of a recent batch of better numbers, the risk of deflation actually looks higher in the eurozone. Those better numbers are little more than an illustration of the usual delayed reaction of the European cycle to developments in the rest of the world. In coming months the slowdown that is currently happening in the US is bound to arrive in Europe. Moreover, the ECB looks very reluctant to even think about the possibility of deflation, let alone act to counter it. Meanwhile, fiscal authorities throughout the region are trying to outdo each other in announcing fiscal austerity plans. Finally, the demographic glacier that will hit most industrialized countries in the next couple of decades has already arrived in large parts of Europe. This all combines into a significant risk of deflation in the eurozone. Q. What does deflation imply for financial markets? A. Not much good If harmful deflation would take hold in developed markets only cash and very high-quality government bonds would hold up. All other asset classes (equity, credit, real estate, commodities, gold, …) are almost certain to suffer severe setbacks. Given the strong links throughout the world economy and global financial markets, even countries that avoid deflation would be hit. So even emerging equity markets would be seriously hit. The helicopter-drop option should eventually be enough to fight off deflation, but at the same time it would also entail substantial risks and cause great turmoil in financial markets. ‘Dropping’ large amounts of money on a deflationary economy might get activity going again, ‘vacuum cleaning’ the excess money at a later stage would be extremely difficult. One thing should be crystal clear, once harmful deflation sets in there will be no easy or clean way out. Even if both the US and Europe avoid deflation in coming years, which is still our baseline scenario, the risk of deflation will remain relevant for markets for quite some time. Only when a sustainable recovery really takes off, markets will be able to sound the all-clear on deflation. That is not something that is about to happen any time soon. It is highly likely that markets will remain concerned about the economic outlook and the risk of deflation for a substantial period of time. Periods of optimism or relief will be followed by periods of disappointment and pessimism about the outlook for developed economies. This implies markets are likely to remain volatile for some time to come.