“Be very, very careful what you put into that head, because you will never, ever get it out.”
— Cardinal Thomas Wolsey on King Henry VIII
So it is with inflation. A generation of economists and central bankers who lived through the 1970s learned that there is a large risk from runaway inflation and that steps must be taken to stop it before it gets out of control.
In reality, the threat these days comes from inflation that is too low, or even from deflation. Many of the world’s economic problems would be reduced if we could get more inflation than we have now.
Unfortunately, some central banks concluded after the first bit of revival from the Great Recession that it was time to tighten credit, lest super low interest rates bring a burst of inflation pressure. They saw a need to confront the possibility of soaring prices before it was too late.
The Swedish central bank, which began to raise interest rates in 2010, in part because of worries about a housing price bubble, completed its reversal of policy on Tuesday, cutting its target interest rate to zero after raising it as high as 2 percent in 2011. But Lars E. O. Svensson, a noted economist who resigned from the Swedish central bank board last year, warned that more steps might be needed, including negative interest rates.
The Swedish blunder was not as great as the one committed by the European Central Bank when it raised rates in 2008 — a worse time to do that is hard to imagine — and then again in 2011. Mario Draghi, who became E.C.B. president in late 2011, has done yeoman work to offset the damage of that policy, but consumer price indexes in several eurozone countries are indicating deflation has arrived.
On Wednesday, the Federal Reserve’s Federal Open Market Committee sort of ended its program of buying long-term Treasury bonds and mortgage-backed securities, known as Q.E. for quantitative easing. But it will not unwind those purchases, at least for the time being. As the securities it owns mature, the Fed will roll over the proceeds into new securities.
Now, with quantitative easing ending, what has the Fed accomplished?
It has helped the economy, although not nearly to the extent that might have been hoped. Inflation, far from accelerating as some conservative economists forecast, has been running consistently below the Fed’s 2 percent target. The Fed’s preferred measure, the index of personal consumption expenditures, is up 1.5 percent over the last 12 months, both overall and excluding volatile food and energy prices. It has been more than two years since either measure was up as much as 2 percent. Imagine the criticism hurled at the Fed if inflation had been running above its target for that long.
What we have not heard from the Fed is any clarification of what it will do if inflation does not pick up, let alone if it falls close to or below zero.
“The real question,” said Jon Faust, an economist at Johns Hopkins University, “is how the F.O.M.C. will express its commitment to getting inflation back to 2 percent.” Until he left the Fed this summer, he was a special adviser to the last two Fed leaders, Ben Bernanke and Janet Yellen.
Mr. Faust was speaking before the Fed’s statement on Wednesday. The answer was that the Fed did not have many words about the question, let alone the “words with teeth” that Mr. Faust believes are likely to become appropriate.
The only dissent at Wednesday’s meeting came from Narayana Kocherlakota, the president of the Federal Reserve Bank of Minneapolis, who in a speech this month said, “In my view, inflation below 2 percent is just as much of a problem as inflation above 2 percent.” He wanted a commitment to push inflation up to 2 percent.
“The likelihood of inflation running persistently below 2 percent has diminished somewhat since early this year” was all the Fed statement had to say about the issue.
There is nothing magic about 2 percent, and some economists think that a 3 or 4 percent target might make more sense. But you don’t have to favor a higher target to realize the current inflation rate is not helping the economy.
At the moment, the threat of deflation is clearly greater in Europe than it is in the United States, and presumably some of the factors forcing prices down, including falling agricultural commodity and energy prices and a strengthening dollar, will diminish as time goes on. But if those weakening commodity prices signal a coming decline in economic activity around the world, the picture could worsen.
What is needed is for Fed officials, and other economists, to make clear some of the damage that low inflation can inflict on an economy. They make adjustments harder for countries that need to become more competitive. Cutting nominal wages is difficult and can be devastating for workers facing fixed costs, like mortgage expenses. But if there is inflation, real wages can decline as nominal wages remain level.
It has become common for some economists to denounce the effect of low interest rates on fixed-income investors, but that is not the complete story. Certainly those with money to invest now face an unappealing set of choices. But those who bought long-term securities years ago — when inflation was expected to be considerably higher than it now is — are receiving more value than they expected.
The much discussed ratio of national debt to gross domestic product also suffers. Consider the 18 nations in the eurozone. Collectively, their national debts rose by 7.8 percent in 2012 and 2013, forcing up the debt-to-G.D.P. ratio by 5.2 percentage points. From 2004 to 2006, their debts rose nearly as rapidly, by 7.4 percent. But the debt-to-G.D.P. ratio actually fell by a percentage point. At the time, European economies were growing and inflation was also pushing up the nominal gross domestic product figures. Now there is little if any growth or inflation, and the result is to worsen the debt picture.
The markets inferred from the Fed’s statement that credit tightening through higher interest rates would more likely arrive sooner than expected, and the dollar rose. If the economic growth and job figures continue to look good, and if inflation manages to rise at least a little, that forecast could be a good one.
But what will happen if inflation — and inflation expectations — do decline? So far, as can be seen in the Survey of Professional Forecasters conducted quarterly by the Federal Reserve Bank of Philadelphia, the 10-year inflation forecast has remained stable at 2 percent. If it began to fall, that would catch the attention of Fed officials.
But the bond market is not so confident. The market inflation forecast can be estimated by calculating the inflation rate at which a purchase of a normal Treasury security would be no better or worse than the purchase of an inflation-protected Treasury security of the same maturity. At the end of last year, the 10-year inflation forecast was 2.2 percent; now it is 1.9 percent. The one-year forecast then was 1.5 percent; now it is a forecast of deflation, negative 0.75 percent.
What could the Fed do if it turns out deflation is a real threat? In theory, it could resume quantitative easing. It could also jawbone Congress to provide more fiscal stimulus. If the Republicans win control of the Senate in next week’s elections, the first alternative might bring angry denunciations from both sides of Capitol Hill. The second might simply be ignored.
As long as deflation is a possibility, the Fed would be well advised to explain, again and again, why inflation that is too low is also bad for the economy. The lesson that high inflation is a threat is well known to politicians and voters. There is a need, as Cardinal Wolsey might have said, to get something else into their heads.
Correction: November 1, 2014Deflation isn't really a "new" risk. It's been a key theme on this blog for as long as I can remember because I've been worried about it from the time I went head to head with Ray Dalio at Bridgewater back in 2004. I was even more worried after researching structured credit markets in the summer of 2006, looking closely at how CDOs-squared and cubed were being (mis)used to fan the flames of the U.S. housing bubble.
The High & Low Finance column on Friday, about the risks of deflation, misstated the market forecast for the 10-year inflation rate. It is 1.9 percent, not 1.7 percent.
But Norris is right, most Fed officials are downplaying the risk of deflation, grossly underestimating the risk of contagion from Europe. On Friday, I discussed the Bank of Japan's Halloween surprise, and stated the following:
Interestingly, the Fed ended its quantitative easing program a couple of days ago and if you read the FOMC statement, it was somewhat hawkish, which makes me wonder if the Fed is on track for making a huge policy blunder.The BoJ's surprise also reinforced the trend in the mighty greenback, sending the U.S. dollar soaring against both the yen and the euro. This too is very important because a significant bullish multi-year trend in the U.S. dollar has huge implications on asset allocation decisions, many of which most pension funds and corporations are ill-prepared for.
Importantly, I think the Bank of Japan is right to be worried and the Fed is too complacent about contagion risks emanating from the euro deflation crisis, taking away the punch bowl too soon. The doves on the Fed, like James Bullard, understand the dangers of deflation spreading to the U.S. and why it's important to leave the door open for more QE down the road, but he's not a voting member. Charles Plosser and Richard Fisher, two of the hawkish presidents on the FOMC, voted to end QE but they will be replacedearly next year and this could change the tenor of debate within the U.S. central bank's policy-setting committee.
I wrote my thoughts on Fed policy last Friday, emphasizing this:...the biggest policy mistake the hawks on the FOMC are making is ignoring global weakness, especially eurozone's weakness, thinking the U.S. domestic economy can withstand any price shock out of Europe. If eurozone and U.S. inflation expectations keep dropping, the Fed will have no choice but to engage in more QE. And if it doesn't, and deflation settles in and markets perceive the Fed as being behind the deflation curve, then there is a real risk of a crisis in confidence which Michael Gayed is warning about. Perhaps this is the real reason why big U.S. banks are loading up on bonds (not just regulatory reasons).
Ironically, the surge is the U.S. dollar is disinflationary and potentially deflationary because it lowers import prices. It also acts as an interest rate increase, tightening U.S. financial conditions. Hence, even though the Fed ended QE and isn't going to raise rates anytime soon, financial conditions are already tightening in the United States via the soaring greenback.
As far as Europe, Jeremy Warner of The Telegraph reports, Deflation: good, bad – and turning ugly:
Filling up the car with diesel the other week, I was pleased to discover something which – at least for someone of my generation – still feels very unusual; the price had gone down – again. And it’s not just fuel. It’s food, it’s clothing, it’s laptops, it’s air fares and much else. Indeed, were it not for the ever mounting costs associated with housing, including rents and utility bills, the CPI inflation rate for the UK last month would have been just 0.8 per cent. The picture for shop prices looks even more dramatic; according to the British Retail Consortium, non food price deflation on the high street accelerated to 3.2 per cent in September.Jeremy Warner is right, there are deep structural factors reinforcing the deflationary trend we're witnessing across the world, and all the monetary and fiscal stimulus won't stop or reverse it.
For those of us who spent our formative years in the inflationary 1970s and 1980s, this is an unfamiliar, even alien world. Back then, the big economic challenge was double-digit inflation, which Britain in particular seemed perennially prone to. Interest rates were repeatedly raised and lowered to cope, entrenching a pattern of economic boom and bust that was devastating for industry. It was not until the Great Moderation of the Nineties and early Noughties that the UK was able to kick the habit.
Today the threat is very different and, many would argue, very much more serious – that of stubbornly persistent economic stagnation and price deflation. That we are still worrying about this a full six years after the start of the financial crisis is itself something of an eye opener. Trillions of dollars worth of central bank money printing was meant to have seen off the spectre of deflation once and for all. Regrettably, it has not.
In Sweden this week, the Riksbank imposed a negative interest rate in a belated attempt to address what is now a virtually two-year stretch of falling prices. At least six of the eurozone economies are in price deflation. To that list can also be added Europe’s second largest economy, France, if the impact of increases in sales taxes is excluded.
Even for economies which are growing again, such as the UK and the US, the picture is not good. Analysis by the investment bank Jefferies shows that the proportion of the US inflation basket where price increases are below 1 per cent is at an all-time high. Similarly, the proportion where the inflation rate is above 3 per cent is at an all-time low. Some 31 per cent of the prices that make up “core” US inflation – that is stripping out shelter, food and energy – are now in outright deflation.
If these phenomena were predicted, it might not seem quite so worrying. Presumably, timely action would already have been taken. Yet the fact is that the US Federal Reserve, the Bank of England and the European Central Bank all find themselves continually wrong-footed in their forecasts of the downward pressure on prices. Despite record low interest rates and the wholesale application of squillions in quantitative easing, all three central banks are struggling to make inflation meet mandated targets. If even growing economies can’t restore equilibrium, what hope the eurozone, where years, if not decades, of low inflation or even outright deflation are fast becoming a virtual certainty?
Economists used to talk about the risks of “Japanification” for Europe. The way things are going, this assessment ought perhaps to be reversed; is there any hope of Europe actually avoiding it? It’s hard to imagine that good old inflationary Britain would ever succumb to this trap, yet in terms of wages, we already have. Not since the 1870s have real wages seen such prolonged and deep erosion. And if the eurozone does fall into outright price deflation, it will undoubtedly drag us down with it. Britain cannot forever remain Europe’s debt-fuelled consumer of last resort.
What’s all the fuss about, some ask? Falling prices – that’s surely a good thing? For those with secure forms of fixed income, it most certainly is; it makes them better off. It is also undoubtedly true that there are “good” forms of deflation, created generally speaking by bountiful, and growing, supply. We can include falling commodity, food and energy prices in this category. When these basics fall in price, it puts money in people’s pockets for spending on other things.
It was this type of “good” deflation that characterised much of the Industrial Revolution, and to a lesser extent the 1920s, when there were productivity-enhancing breakthroughs in the application of technology that massively expanded supply. Prices dropped, but consumption, living standards and output boomed.
Admittedly, there are elements of this type of deflation in present pricing pressures. Since the 1960s, the price of a unit of computing power as measured by Floating Point Operations Per Second (Flops), has fallen from an astonishing $8.3 trillion in today’s money to little more than 10 cents. These gains have driven major gains in productivity and substantially changed the nature of work, growth and output.
Yet unfortunately they are probably a comparatively minor part of today's deflationary story. Current deflationary pressures seem substantially to be made up of the “bad” variety, particularly in the eurozone – the kind that stem from financial crises, deep recessions, and big debt overhangs, where demand is depressed below the level of supply. The reason why bad deflation is not a disease you ever want to succumb to, and why central bankers spend so much time obsessing over it, is that once entrenched, it’s very hard to get rid of. Inflation can easily be tamed simply by bearing down on demand with higher interest rates. Lifting demand is far more problematic, however, and once rates reach the zero bound, seemingly well nigh impossible.
If prices are falling, consumers postpone spending decisions in anticipation of getting a better deal tomorrow, and instead save more. This depresses demand, causing companies invest less, employ less, and pay less. Soon a vicious cycle of declining demand establishes itself, made worse by any sizeable debt overhang, the burden of which grows as real wages shrink, making people even more averse to spending.
Sometimes both “good” and “bad” deflation are present, as in today’s falling supermarket prices. The “good” comes from the price war unleashed by the discounters, Aldi and Lidl among them. The “bad” comes from the fact that falling real wages has depressed demand. Consumers have to make less go further.
Yet even accepting that today’s deflationary pressures are substantially demand led, or “bad”, in nature, it is not clear that ever more extreme forms of monetary activism are the answer. There is a good reason why central bankers are desperate to wean their economies off the adrenalin fix of quantitative easing, and why the Federal Reserve for one is so relieved to have brought its programme of asset purchases to a conclusion this week: if it ever did work, it’s self evidently not doing so any longer.
By creating new asset bubbles, sowing the seeds for future financial instability, and widening the wealth divide, it’s also been generating some very undesirable side effects. Monetary activism may have helped save the UK and the US from greater calamity after the financial crisis, but it only steals growth from the future and from others. One effect of loose money is currency devaluation, which might give a temporary boost but merely shifts the deflationary problem onto other states. This in turn produces a race to the bottom as each country attempts to outdo the other. Globally, it’s a zero sum game.
Fiscal stimulus and credit expansion have also been tried, and so far succeeded only in sending national debt levels skyrocketing, for no lasting effect in terms of growth.
In my view, all these approaches are based on a fundamental misunderstanding of what the crisis is all about. The downturn was never just some cyclical aberration that could be easily overcome via traditional monetary and fiscal demand management. Rather, it was a manifestation of deep structural problems – excessive debt in some areas; excessive saving in areas – both within and between national economies.
Until these structural imbalances and supply-side deficiencies – such as the UK’s pitifully inadequate levels of housebuilding – are addressed at national and international level, low inflation and becalmed living standards may be about the best we can look forward to.
Central banks are fighting a losing battle and their attempts to reflate risk assets will only deepen the wealth divide, which in and of itself is also deflationary (how long can the top 10% of households prop up the recovery?). Worse still, more quantitative easing is sowing the seeds of another huge crisis which will eventually hit everyone hard.
But central banks don't have much of choice. If they stand idle, deflation will set in, making their job to achieve their inflation target that much more impossible. And they can't count on politicians to promote pro-growth policies because dysfunctional politics and fiscal austerity are pretty much the new norm everywhere nowadays.
People don't understand deflation. They think it's all rosy but it isn't. I just visited the epicenter of the euro crisis in September and saw firsthand the ravages of deflation. Significantly lower wages, pensions and real estate values are wreaking havoc on the Greek economy. The same thing is going on in Spain, Italy and Portugal and France will soon follow.
This represents a significant and protracted price shock that can spread throughout the world. The main focus now is on the U.S. recovery and better employment but if the Fed doesn't keep its eye on the euro deflation crisis and contagion risks, it will be making a terrible policy blunder. And I think markets are extremely nervous about the Fed and the ECB falling behind the deflation curve (more the Fed because most people have given up on the ECB engaging in massive quantitative easing).
What else worries me? I think policymakers and economists are overestimating the strength of the U.S. economy, which is still sending mixed signals at best. There is a recovery going on but it's a slow, grinding recovery and the quality of the jobs being created are nowhere near as good as in past booms. It's even worse in Canada, where I fear complacency is leaving Canadians ill-prepared for the storm ahead.
I'm sorry I couldn't be more cheerful but I think a lot of institutional investors are going to get clobbered in the years ahead because they underestimated the risks of deflation spreading to North America. For now, it's "only a European problem," much like the Germans were saying about Greece ("it's only a Greek problem"). Yeah right, keep hoping, but that's not a strategy.
Below, CNBC reports that bond investing guru Bill Gross is warning that deflation remains a growing possibility despite aggressive monetary policies by central banks around the world. In his second investment outlook letter since quitting Pimco, the bond firm he co-founded more than four decades ago, to join Janus Capital Group in September, Gross said history shows that economies experience periods of both inflation and deflation, and both "are the enemies of stability and growth."
Also, on Friday, Brian Kelly was on CNBC and likened the BoJ's Halloween surprise to a Bear Stearns event."What they did is outrageous. It is a terrible idea," he said. "It is going to have massive, massive ramifications. The U.S. stock market hasn't woken up to it yet, but they absolutely will. First thing that's going to happen is we're going to get deflation over here in the U.S."
He's wrong castigating the Bank of Japan for engaging in more QE but right on one thing, deflation will eventually come to the United States and far too many investors are grossly ill-prepared for it.