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THE JEROME LEVY FORECASTING CENTER
June 2010
David A. Levy, Chairman
Client Memo
Confidential
Widespread Fear of the Wrong Kind of Price Instability
It is not inflation but more disinflation and ultimately deflation that lie ahead in the 2010s
Inflation worries remain a major part of the market backdrop, and the past year has brought new price
stability concerns to investors. During that time, we
have written about inflation fears, deflation risks, and
the relationships between price trends and monetary
policy, fiscal policy, Treasury debt levels, foreign debt
holdings, and various other issues. We have argued
that rising inflation will not be a threat in the coming
years and that disinflation and some deflation are the
real worries. Our position remains unchanged.
This updated summary of our analysis is the most
comprehensive piece we have written on the outlook for
pricing in many years. It is composed partly of excerpts
from our writings over the past year or so, but it also
contains new material, largely addressing issues raised
by clients such as quantitative easing, trillion-dollarplus deficits, and the consequences of larger-scale war.
inflationary influence must either widen profit margins
or increase costs. Profit margins tend to rise and fall
cyclically but cannot continue rising for long, so sustained inflation ultimately depends on rising costs. Viewing the whole of private business as a monolith,
business’s two primary components of cost are labor
and imported materials costs, with the former much
larger than the latter. In the years ahead, chronic high
unemployment will weigh heavily on labor costs; chronic
economic weakness will tend to keep profit margins
under pressure and firms focused on cost control; and
global instability and large areas of depression (contained or otherwise) will reduce upward pressures on
prices of imported commodities and are likely to cause
these prices to fall much of the time.
Even if imported commodity prices, most notably
oil prices, rise sharply at times, they will not have a
large, lasting effect on inflation as long as labor costs
are decelerating or actually falling. Labor costs are the
dominant inflation influence (chart 1) not only because
they are the single biggest component of prices, but
also because labor costs are heavily affected by com-
1. Why It Will Be Very Difficult for Inflation to Accelerate in the Next Few Years
The dominant influence on price trends in the near
future and for years to come will be the deflationary
influence of chronically high unemployment. The
economy not only has gone through a deep recession
but also has entered a contained depression, a long
period of substandard economic performance, chronic
financial problems, and generally high unemployment.
The contained depression is likely to last about a decade; it will end in the latter half of the 2010s at the
earliest and could stretch into the 2020s.
Any price can be divided into two components,
cost and profit margin, so something that causes inflation must alter at least one of these components. The
©2009 by The Jerome Levy Forecasting Center
THE DOMINANT FACTOR FOR INFLATION
CHART 1
Business Sector: Unit Labor Costs
Gross Domestic Product: Implicit Price Deflator
20-quarter % change, annualized
8
6
GDP deflator
4
unit labor costs
2
0
shaded areas indicate recession
-2
52
1
58
64
70
76
82
88
94
00
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pensation rates, which fuel consumer spending and are
therefore tied to the ability of firms to pass on inflationary price increases to consumers. By contrast, oil
prices, which are widely believed to be a critical inflation signal, have a weaker relationship to inflation over
time, although they can be an important short-term influence.
Labor cost inflation will remain subdued or even
negative as long as unemployment remains high, and
the prospects for a real recovery in labor markets are
poor. A tightening labor market—a falling unemployment rate—would at some point trigger inflationary pay
increases. Conversely, any unemployment rate that is
substantially above such a trigger point indicates excessive competition for jobs and a tendency for pay
raises to shrink—or pay cuts to become larger and
more common. The trigger point, which varies from one
business cycle to another depending on a variety of
circumstances, is by any reasonable estimate far below the present figure of nearly 10%. Over the past
quarter century, that point appears to have ranged from
a 4.5% to a 6.5% unemployment rate.
Let’s assume conservatively that the unemployment rate only has to fall to 6.5% before compensation
inflation begins to accelerate. Let’s also assume optimistically that unemployment falls a percentage point
every year starting in June 2010—considerably sooner
and faster than it did during either of the past two expansions. Even with these assumptions, the unemployment rate would not hit 6.5% until August of 2013. Most
likely, the recovery in employment will probably take
years longer. Moreover, especially with deflationary fears
in place, the trigger point is likely well below 6.5%.
2. Why Aggressive Monetary Policy Isn’t Causing—and Won’t Cause—Inflation
The notion of an inexorable link between monetary policy and inflation is pounded into our brains by
the prevailing economic wisdom: “inflation is a monetary phenomenon,” “inflation is too many dollars chasing too few goods,” “central banks pump money into
their economies to inflate their way out of trouble,” and
so forth. Yet creating more reserves in the system does
not under all circumstances lead to additional demand,
and if it does not, it cannot affect prices. True, under
normal circumstances, easier money means lower interest rates, more credit creation, and more demand
associated with that credit creation. But that’s not what
happens when the economy faces what has been called
the “liquidity trap,” when increasing the money supply
does not induce more activity.
There are various theoretical reasons given for the
liquidity trap, but let’s just focus on what is happening
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now and what is likely to happen in the years ahead.
Presently, excess reserves are not inducing lending for
several reasons, and adding to them further will not
make much difference. First of all, banks are capital
constrained, not reserve constrained. Second, interest
rates could not fall far enough during this business cycle
to enable troubled debtors to refinance their way out of
trouble, so now banks remain worried about the volumes of bad debt they are carrying and how future loan
losses will impinge on earnings and capital. Third, deflationary expectations are beginning to work their way
into banks’ loan evaluation process on a micro level; in
more and more areas, loan officers are looking at households with shrinking incomes and firms with deflating
revenues. Fourth, the private sector has too much debt,
and many households and firms are trying to reduce
debt, especially as more of them worry about deflation
in their own incomes or revenues.
Should broad-based deflation develop, banks will
have a strong incentive to seek the safety and real returns of Treasuries and become even more conservative about lending standards. The economy would have
to be strong for several years—long enough to greatly
reduce unemployment, raise capacity utilization rates,
and shift expectations away from deflation—before the
flood of reserves could lead to strong net credit creation, strong profit sources, fat profit margins, and upward pressures on costs. That will not happen before
the contained depression is over unless deficit spending becomes so vast, perhaps a sustained two trillion
dollars a year or more, that the economy does begin to
grow rapidly enough to reduce the slack briskly. The
political process is unlikely to allow such fiscal policy
to be pursued, especially for several years running,
barring extraordinary circumstances.
3. Why Large Government Deficits Won’t Cause
Inflation
A large government deficit does not necessarily
cause surging inflation (look at Japan over the past 2
decades, for example). Large deficits are all but inevitable in the United States, yet they will not cause inflation over the next decade. Fundamentally, high government spending cannot cause inflation unless and until
it begins to overheat the economy.
To see why the deficit is not likely to overheat the
economy, consider where profits are coming from at
present. Due largely to a collapse in net investment
(chart 2), the federal deficit (a profit source) is more
than accounting for all of domestic corporate profits
(chart 3). In other words, without huge deficits, profits
in the second quarter and again in the third would have
given way to net business sector losses (national in-
lem threatening the country’s survival by spending trillions of dollars financed with massively larger deficits—
as during World War II—overheating is likely to be the
least of the country’s problems.
CHART 2
NET PRIVATE INVESTMENT AT A HISTORIC LOW
Net Private Investment as a share of GDP
%, seasonally adjusted
12
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4. The Rapid Increase In Public Debt Is Not Likely
to End in Disaster
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Although public debt issuance is massive at
present and will continue to be so, total debt issuance—
public plus private—is much smaller than it has been
in recent years, and it will remain depressed. Public
debt growth may have accelerated to roughly $2 trillion
annual rate, but net private debt issuance will likely be
minimal or negative for many years as the private sector delevers; private debt growth had been running at
about $4 trillion annual rate in recent years but has
shifted into reverse, becoming negative (chart 4). Thus,
although the federal debt is rising rapidly, the total debt
level in the economy is not.
Still, the debt owed by the government is considered an inflationary threat by many who fear that someday the government will be so overwhelmed by debt
service obligations that it will have no choice but to
“inflate its way out of the problem.” Accordingly, it is
important to look at the outlook for the federal debt, its
manageability, and its ultimate resolution.
The federal debt held by the public is likely to
expand enormously over the coming decade, probably
to well over 100% of GDP (chart 5). However, there are
reasons to believe that it will remain manageable, and
that it will not necessarily be a cause for rising inflation
in the years ahead.
This outlook for the federal debt and debt service
burden is a large and multifaceted topic, and we will
address it at some length in a separate piece in the
weeks ahead. It will explain how, eventually, the contained depression will run its course, and the pressures
for reviving private investment will become overwhelming. The resurgence of private investment after years of
weakness, deflating asset prices, and write-offs will
generate strong profits that lift the economy from its
0
47
52
57
62
67
72
77
82
87
92
97
GOV'T DEFICIT MORE THAN ACCOUNTS FOR PROFITS
02
07
CHART 3
NIPA: Corporate Profits and Profit Sources, 1Q 2010
$
adjusted, annual rate
$ billions,
billions,seasonally
annual rate
1500
1000
personal &
foreign
saving
500
other
0
-500
-1000
adjusted
domestic
profits
gov't
deficit
net private
investment
dividends
come and product accounts basis), a situation far worse
than anything witnessed since the Great Depression.
Without profits, of course, firms cannot stay in business, employ workers, or meet their financial obligations.
Looking ahead, it appears likely that profits will
remain heavily if not entirely dependent on government
deficit spending for most of the next several years. The
only way the private economy would be able to generate significant profits on its own would be through a
resumption of rapid expansion of private balance sheets.
While theoretically possible, this scenario appears unlikely. The household sector has far more debt than it
can handle under present circumstances, and home
prices and construction cannot recover meaningfully
without extremely easy mortgage lending conditions,
which will not return. The nonfinancial corporate sector
has record-high debt levels, and the financial sector is
under pressure to deleverage.
Although it is theoretically possible that the deficit could grow large enough to overheat the economy,
there is no sign of such a thing on the horizon, and we
doubt that it will occur. Already, private commentators
and public officials are voicing deep concerns about
the size of the deficit and the national debt. Only the
weakness of the economy prevents major efforts to cut
the deficit. If the economy begins to improve significantly, budget cutting is likely to pick up a lot of political steam. It would take a long time to get from where
the economy is now to the verge of overheating. Absent
a compelling, national arousal to tackle some new prob-
TOTAL DEBT IS DECLINING
CHART 4
Credit Market Liabilities: Private Sectors and Government
$ trillions, quarter-to-quarter change, seasonally adjusted, annual rate
private
government
total
5
4
3
2
1
0
-1
-2
-3
00
3
01
02
03
04
05
06
07
08
09
10
TREASURY DEBT HELD BY PUBLIC
CHART 5
Gross Federal Debt Held by the Public as % of GDP
$ billions, seasonally adjusted, annual rate, 2009 predicted
1946: 109%
100
75
1956: 52%
50
25
0
39
49
59
69
79
89
99
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dependence on deficit spending. As revenues strengthen
and social safety net spending eases, the deficit will
tend to narrow rapidly on its own. As in the late 1940s
and early 1950s, the debt-to-GDP ratio is likely to fall
rapidly.
5. What About Inflation Caused by a Collapsing
Dollar?
Another fear is that the dollar may collapse, leading to higher import prices and thus rising domestic
inflation. The case for a free-fall in the exchange value
of the dollar that would bring it to a fraction of its present
value does not seem plausible. However, it is certainly
possible that the dollar will depreciate significantly and
experience high volatility.
If the dollar does depreciate markedly—by 10%,
20%, or even more—a large portion of the exchange
rate shift would be absorbed by exporters to the United
States. Overcapacity among exporters to the United
States has increased U.S. consumers’ pricing power
and exporters’ propensity to sacrifice margins for volume. As such, much of the effect of dollar depreciation
would be disinflationary pressure abroad rather than
inflationary pressure here. Increases in U.S. import
prices would likely have a significant but not huge or
lasting overall effect on U.S. inflation.
To the extent that U.S. import prices do increase
as a result of a cheaper dollar, the prospect for sustained inflation to become established still remains very
limited because of weakness in pay trends.
6. Stark Differences Between Late-2000s-2010s Period and the Late-1960s-1970s Period, when Growing Government Deficits Accompanied Escalating
Inflation
Exploding deficits at a time when the government
is involved in foreign wars and working on ambitious
new social initiatives suggests to many investors a replay of the late 1960s and 1970s, when inflation broke
out of its moderate postwar range and marched to an
alarming double-digit pace. Yes, there are parallels be-
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tween the soaring federal spending in the present era
and that of the late 1960s, but in many ways the two
periods are as different as night and day. Moreover,
while it is true that the deficits of the earlier period contributed to the development of inflation, they were hardly
the only or even most important cause of inflation, especially in the 1970s.
Clearly, both the size and the rate of expansion of
the federal deficit, in proportion to GDP, are larger in
this period than forty years ago, and the growth in federal spending is also larger in the present era (charts 6
and 7). Nevertheless, all of this fiscal stimulus is occurring in a beleaguered private economy that would
otherwise collapse and, even with the enormous federal fiscal stimulus, will have high unemployment, low
capacity utilization, serious ongoing financial problems,
and extremely weak net private investment. By contrast, the economy of the late 1960s had sound finances,
low unemployment, powerful investment, low debt levels, and an extremely high capacity utilization rate.
Manufacturing capacity utilization averaged about 88%
in the late 1960s, the highest of any five-year period
since World War II; in 2010-2014, Americans will be
lucky if it averages above 70%.
We have already seen another period of soaring
and then persistently large deficits during which inflation went down, not up: the years of the Reagan administration. The biggest deficits of the 1960s, when inflation began to rev up, were only about 2% as large as
GDP, and in the 1970s they were still in the 1% to 4%
CHART 6
FEDERAL GOVERNMENT EXPENDITURES AS % OF GDP
Federal Government Total Expenditures as a % of GDP
%, seasonally adjusted
26
24
22
20
18
16
60
65
70
75
80
85
90
95
00
FEDERAL GOV'T NET BORROWING (NEGATIVE) AS % OF GDP
05
10
CHART 7
Federal Government Net Lending or Borrowing (-) as a % of GDP
%, seasonally adjusted
3
0
-3
-6
-9
-12
60
65
70
75
80
85
90
95
00
05
10
range. Yet in the early 1980s, deficits of more than 5%
of GDP accompanied falling inflation. Keep in mind that
while cyclical factors heavily influenced deficits in all of
these periods, the deficits of the 1980s were also largely
tied to non-cyclical factors. The growth of social programs by the 1980s was a major budgeting problem,
even though the programs were not enhanced by legislation during those years. Also, the increase in military
spending in the 1980s was substantial and eventually
comparable to the late 1960s rise in defense spending,
albeit not as abrupt.
Now, the issue is deficits that are 10% of GDP as
opposed to 2% in the 1960s and 5% in the 1980s. The
size is and will be much more a function of the condition of the private economy than of federal policy; in
this period the economy will tend to contract until deficits become large enough to support profits. The deficit increases may be the result of falling revenue and
rising social insurance payments, or the result of new
spending or tax initiatives in response to the economic
situation. (In 2008 and 2009, for example, most of the
widening of the deficit reflected falling revenues and rising social insurance payments, but legislative acts
added a few hundred billion dollars of deficit spending).
If a recovery in the private economy gains any strength,
revenues will rise, Congress will likely limit spending,
and deficits will tend to shrink. However, unlike during
past business cycles, deficits will not shrink much before the economy begins to flag again.
So why aren’t deficits this large likely to lead to
inflation, especially with easy money, too? Because
the problems in the economy are so deep that the deflationary forces will more than offset the inflationary
influence of government fiscal activity. The government
will be injecting a quart or two of inflationary pressure
into an economy that has a gallon of deflationary pressures.
bit more complicated. Spending on defense, whether
on war, peacetime military activities, or capital accumulation by the armed forces, represents part of the
economy’s output that does not go into goods and services that people recognize as part of their standard of
living. (Defense spending is not the only such expense;
the same is true of current business capital spending
and net exports. These items may have future benefits,
including enhancing the standard of living, but in the
present they take potential production away from consumer goods and services.)
Whether paid for with deficit spending, higher
taxes, or reducing other government services, war
spending that takes away from households’ living standards or quality of life makes people feel deprived, and
such dissatisfaction can lead to demands for higher
pay. However, the impulses that generate such demands
will have little influence in this environment, when high
unemployment already has many workers accepting
pay cuts rather than go jobless.
Moreover, any fears that war spending will undermine the standard of living fade considerably upon noting that the resources being devoted to defense are not
a historically high portion of GDP. Chart 8 shows the
percentage over the history of the national income and
product accounts from 1929 on. (Chart 9 shows the
last 50 years to remove the huge World War II readings
to allow a smaller y-axis scale.) If the ratio were to rise
from 5% in 2008 by two or three percentage points,
that would represent a huge increase, but whether it
DEFENSE CONSUMPTION AND INVESTMENT AS % OF GDP
CHART 8
National Defense Consumption and Gross Investment as % of GDP
%, annual
40
30
20
7. What About Increased Spending On War? Could
That Spark Inflation?
10
0
29
Government spending on war can be inflationary,
but it would take an enormous expansion of the present
war efforts to put much upward pressure on inflation.
Spending on defense can create inflationary pressure in two ways. One is if heavy defense spending
contributes to large public deficits, which can in some
circumstances cause overheating in the economy. Unless the scale of U.S. spending on foreign wars is multiplied several times, we still think deficits will be less
than needed to fully offset the weakness in the private
profit sources.
The other way defense spending can cause inflation, which we do not see as a meaningful threat, is a
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49
59
69
79
89
99
DEFENSE CONSUMPTION AND INVESTMENT AS % OF GDP
09
CHART 9
National Defense Consumption and Gross Investment as % of GDP
%, annual
15
12
9
6
3
0
47
5
57
67
77
87
97
07
would make a sizable difference in the outlook would
depend on other fiscal policies. Whether there will ever
be political support to escalate one or more of the
present war efforts on that scale remains to be seen.
8. Could the Economy Begin to Overheat When
the Contained Depression Is Over, Leading to Rapidly Rising Inflation?
As long as the contained depression persists,
and our best estimate is that it will last roughly a decade, the primary threat to price stability will remain
deflation rather than inflation. Japan provides a graphic
example of how an economy in contained depression—
in Japan’s case, for nearly two decades—can run huge
deficits, accumulate massive government debt, and still
experience disinflation and deflation.
The real inflation question concerns what will happen once the contained depression ends. Although the
future that far out holds many uncertainties, it appears
that occasional spikes will be more likely than an ongoing upward wage-price spiral after many years of
disinflation or deflation.
Three factors are likely to hold down inflationary
pressures. First, the private investment boom that will
mark the end of the contained depression is likely to
bring with it productivity gains, provided that the investment is leading to more and better products, not the
elimination of threats (such as building massive sea
walls around coastal cities to guard against rising seas
due to global warning—a hypothetical example—the
last thing we will try to predict is climate change!). Keep
in mind that when investment is weak for a decade, the
average age of the capital stock becomes unusually
high, the equipment becomes unusually worn and unreliable, and the gap between technology in place and
the technology available becomes unusually wide. Thus,
the productivity gains from new investment would be
huge, as after World War II.
Second, the contained depression’s disinflation
and deflation episodes will make employers extremely
reluctant to grant large raises for a long time into the
era of reinvestment and growth that we anticipate will
follow. As the U.S. and, in all probability, global economies both pick up, demand for commodities and other
goods may surge relative to supply, pushing prices up.
It is possible that short-term spikes in inflation could
result, but unless and until workers begin to get large
pay increases, a sustained acceleration inflation will
not occur.
Third, we expect some tightening of monetary
policy to follow the return to prosperity, and prosperity
will help make efforts at fiscal restraint successful.
Thus, the potential for the economy to overheat may be
limited.
Surely, commodity price shocks and policy mistakes will occur in the future, but the economy will probably remain resistant to a wage-price spiral. It will take
some doing to establish rapid inflation in the U.S.
economy if it has been absent for a long time.
The Jerome Levy Forecasting Center LLC—the world leader in applying the macroeconomic profits perspective to
economic analysis and forecasting—conducts cutting-edge economic research and offers consulting services to its clients. The goal
of the Levy Forecasting Center is to improve its clients’ business and investment performance by providing them with powerful
insights into economic risks and opportunities, insights that are difficult or even impossible to achieve with conventional
approaches to macroeconomic analysis.
©2010 by The Jerome Levy Forecasting Center LLC. Based on a client memo originally published in November 2009. Redistribution
of this publication in its existing form is permitted; reformating or redestributing without attribution is prohibited.
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