Wednesday, August 19, 2009

Worried about deflation

News from the inflation front (except in the UK) remain strongly disinflationary and suggest that the deflation risk is still growing.
Yesterday's US PPI release was a case in point. The yoy rate dropped to -6.8% from -4.6% in June. This is a new post-WWII record low (see chart)! Furthermore, never since WWII has the yoy rate dropped as fast and as far (down from +9.8% as recentely as August 2008) as over the past 11 months.
Source: Bloomberg

The high level of underutilised capacity (aka the output gap) as is evident by the record low capacity utilisation rate and high levels of unemployment suggest that imminent pricing power by corporates and households remains weak and inflationary fears remain overdone. Not only are headline inflation rates negative in the US and the Eurozone but more importantly core inflation rates have started to come down significantly. US core inflation dropped from 2.5% in September 2008 to 1.5% in July this year. During the same period Eurozone core inflation fell from 1.9% to 1.3%. The levels of the last recession (1.1% in the US and 1.2% in the Eurozone) are approaching fast and are very likely to be undershot significantly and for a prolonged period of time.
Source: Bloomberg

I have also written on several occasions about the low medium-term inflationary threat posed by the lenghtening of the US Fed's balance sheet (see for example Not again: inflation - or the lack of it). Basically, broad based credit aggregates are falling by more than narrow-based monetary aggregates are rising. However, once broad-based credit aggregates are rising again (which can take a long time as it needs both, banks which are willing to lend and households/corporates which are willing to borrow), we should also expect narrow-based monetary aggregates to fall again. The ultimate inflationary pressure will be very limited and take a long time before it becomes evident. For the time being, we still have too little money chasing too many goods resulting in disinflation.
In this respect, I still think that current break-even inflation rates priced into US Tips and Eurozone linkers appear too high. In fact, I expect them to trade slightly below the 1.5% area in 10y within the next few months and therefore recommend to underweight linkers vs. nominal govies in the US and the Eurozone (not so in the UK where the inflationary threat seems much larger, see Revisiting the UK - not much good news).
Source: Bloomberg

One additional point: Bloomberg columnist Matthew Lynn argues in Deflation Theory is Lemon we have all been sold that deflation is no threat at all as historically falling prices went frequently hand-in-hand with healthy economic growth. I agree that there exists a so-called 'good' deflation (falling prices caused by technological progress). In fact the deflation scare early this decade can be attributed largely to the 'good' variety on the back of technological progress and globalisation. However, there clearly exists also a 'bad' variety of deflation, the one caused by a debt-deflation spiral, something Mr Lynn completely ignores. In such a debt-deflation spiral everyone wants to reduce indebtdedness which leads to a recession, rising unemployment and falling prices. As prices fall, real indebtdedness increases further, a vicious circle. While technological progress has not really been abating, also helping to limit inflation fears, the current deflationary threat resembles a debt-deflation spiral (at least in the US).
The chart below shows the development of a proxy for nominal weekly earnings with recessions shaded in grey. I calculated it using the index of aggregate weekly hours multiplied by the average weekly nominal hourly earnings (for further details please refer to: Consumer deleveraging spiral still getting worse). Nominal earnings for private sector employees are contracting at an unprecedented post-WWII speed. Over the past twelve months they have been dropping by 4.3%! It is very difficult for households to reduce debt on average if their incomes are deflating and therefore their debt is increasing in real terms.
Source: BLS, Research Ahead

Overall, I remain more worried about the disinflationary process than the inflationary threat and expect US and Eurozone break-even inflation rates to tighten again in the months ahead.

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