Deflationary threat: good or bad?

I have frequently stated that most of the so-called developed markets will see only very limited inflation pressures for the next several years (with a significant risk of an inflationary outcome in the UK, however). This per se does not need to be bad for an economy. Rather to the contrary, I think that a low-inflation outcome can help countries such as Germany, France & Switzerland which do not have an overindebted household sector to shift their focus more towards domestic consumption (and away from exports) amid raising purchasing power. On the other side, in countries with over-indebted consumers such as the US, a low inflation outcome can be much more damaging for the economy as it increases the risk of a debt-deflation spiral.

Macroblog has some interesting charts on the US inflation development:

To quote macroblog: "A key observation to take away from this picture isn't the recent acceleration in core goods prices. The highly volatile behavior of goods prices tends to make them an unreliable guide to underlying inflation trends. Rather, it is noteworthy to consider the significant downward trek of core services price growth. Indeed, the 12-month trend in core services prices was a shade under 1.6 percent in July—its lowest reading in the post-WWII era and roughly 1¾ percentage points lower than this time last year."
I would add that the deflation scare earlier this decade following the bust of the dot-com bubble stemmed almost exclusively from the drop in goods prices. However, relatively more goods are tradable internationally than services and therefore international competition should play a larger role in influencing goods prices. Services prices, on the other hand, should be relatively more influenced by domestic factors. The drop in goods prices itself is likely to have stemmed from increasing globalisation as well as technological progress. This, however, is rather a positive deflationary threat down to productivity gains which helped render households richer in real terms (as they have to spend less for their goods consumption).

This time, however, the deflationary threat in core CPI stems largely from the services component. To quote macroblog again: "Some of the downward pressure on core services prices is a direct reflection of the housing crisis; a little more than half the core services price components are computed from housing rents. But that's not the whole story as a rather sharp disinflation was evident in core services excluding rents."

Services are usually more labour intensive to produce than goods (and again, the share of imports in goods conumption is higher than in services consumption). As a result, the strongly disinflationary trend in core services CPI adds to the need of cost-cutting measures which in the services sector means headcount reductions, even more so than in the goods producing sector.

Furthermore, if we look at the development of personal income (see chart below), then the picture becomes even more dramatic. Personal income is down by around 2.4% over the past 12 months. The last time personal income dropped by this amount was for a brief period just after WWII. However, personal income never dropped during the past recessions.

US personal income yoy vs. recession

Source: Bloomberg

Amid the strong disinflation in core services CPI as well as the fall in personal income coupled with the highly indebted households, I continue to see the risk of a bad deflation outcome in the US, i.e. one where the gain in purchasing power amid lower prices does not outweigh the additional burden brought about by higher debts in real terms.

The situation is different, though, in countries where households are not overly indebted (and house prices are not falling) such as Germany, France or Switzerland. Here, the positive effect on purchasing power by the currently low to negative readings in CPI promise to be far more substantial. For one, households balance sheets are not overly leveraged (i.e. households indebtedness is relatively low) while house prices have not bubbled to the same extent as elsewhere and are therefore not dropping significantly at present. Furthermore, so far unemployment has risen only moderately, leaving personal income largely intact. In turn, the current low to negative CPI further supports the rebalancing of these economies away from their large export-dependency (especially in Germany and Switzerland) towards more domestic consumption.