Will Deflation Expose Naked Swimmers?
Janet Yellen and Mario Draghi have a new reason to consider what International Monetary Fund chief Christine Lagarde calls the “ogre” of deflation: eroding confidence in emerging markets.
Weaker growth from Brazil to South Africa risks unleashing a “disinflationary impulse through the global economy,” said Bruce Kasman, chief economist at JPMorgan Chase & Co. in New York. Cheaper commodities, slower trade and sliding exchange rates in developing markets all could soften price pressures internationally.
That in turn could force Federal Reserve Chair Yellen and European Central Bank President Draghi to keep monetary policy loose for longer, increasing the attractiveness of their financial assets even at the threat of creating asset bubbles.
“Emerging market volatility is likely to continue,” said Roberto Perli, a former Fed economist and now a partner at Cornerstone Macro LP in Washington. That “over time could lead to easier monetary policies than large central banks would have otherwise preferred, mainly through potential disinflationary effects.”
Perli says that would be supportive of assets in the developed world, whose outperformance is shown by the MSCI World Index’s 17 percent gain of the last year. Its emerging-market equivalent is down 10 percent.
The dynamics of the world economy will be debated this week when central bankers and finance ministers from the Group of 20 gather in Sydney. For the first time since the G-20 became the premier forum for economic policy discussion in September 2009, it is officials from developing nations who are on the defensive as growth fades and markets tumble.
In contrast, the U.S. and Europe will be at the forefront in powering a pickup in global growth this year, to 3.7 percent from 3 percent in 2013, according to the IMF.
Managing Director Lagarde said rich nations can’t be complacent. “We see rising risks of deflation, which could prove disastrous for the recovery,” she said in a speech in Washington on Jan. 15. “Deflation is the ogre that must be fought decisively.”
Central bankers so far don’t sound concerned. Yellen told lawmakers on Feb. 11 that some of the recent softness in prices “reflects factors that seem likely to prove transitory” and the trading volatility sparked by emerging markets doesn’t pose a “substantial risk to the U.S. economic outlook.”
Draghi said Feb. 6 that while “there’s certainly going to be a subdued inflation,” deflation is not a risk. Europe is strengthening and price declines outside of food and energy are mainly limited to the so-called peripheral economies, which need to adjust to become more competitive, he said.
Strategists at Barclays Plc have a different view of the euro area, where inflation of 0.7 percent is already less than half the ECB’s target. They calculate the currency union is the most vulnerable to region-wide deflation since the final quarter of 2009, when the world economy was just starting to recover from the deepest recession since the Great Depression.
Kasman’s team at JPMorgan estimates inflation in advanced nations will end the year at 1.7 percent, less than the 2 percent rate many central bankers regard as price stability. Sluggish demand has hurt the ability of companies to raise prices, while high unemployment makes it difficult for workers to win higher wages.
Kimberly-Clark Corp., the Dallas-based maker of Huggies diapers and Kleenex tissues, said on Jan. 24 that net selling prices in North America for its personal care group fell 2 percent in the fourth quarter from a year earlier. “We wanted to be a bit more competitive on the shelf every day,” Chief Executive Officer Thomas Falk said on a conference call.
Compounding the concern about falling prices is the slowdown of emerging markets, which account for about 40 percent of global gross domestic product. India, South Africa and Brazil were among those to raise interest rates last month as investors dumped their currencies.
More tightening of policy is likely. Bank of America Corp. predicts South Africa, Brazil, South Korea, Hungary and Malaysia will all boost benchmark rates by the end of this year.
Declining demand from such countries will put downward pressure on commodity prices, potentially imparting another disinflationary wave worldwide. Although the Standard & Poor’s GSCI Spot Index is little changed this year, Michala Marcussen, global head of economics at Societe Generale SA, said the larger sway emerging markets have over global GDP means any slackening now could “have a much greater impact” on prices.
The U.S. and other advanced economies could also feel a pinch if their currencies continue recent gains against those of developing countries, hurting their trade position and making prices of goods from abroad cheaper.
A Bloomberg index tracking the 20 most actively traded emerging-market currencies has fallen 9 percent over the last year, while the dollar has risen 4 percent on a trade-weighted basis.
Import prices in the U.S. declined 1.5 percent in January from a year earlier, after dropping by the same amount in the 12 months ended January 2013, according to the Labor Department in Washington.
Much depends on how China holds up, given that it’s now the world’s second-largest economy as well its biggest importer of soybeans, cotton and iron ore. Leaders’ efforts to rebalance growth away from investment, which accounts for about half of GDP, and toward domestic demand could weaken prices elsewhere as raw-materials imports fall, said Nick Kounis, head of macro research at ABN Amro Bank NV in Amsterdam.
“Even in a soft-landing scenario you’re seeing changing demand patterns, which means commodity prices will be more subdued,” he said.
Falling prices for items such as oil also could be “positive” for developed-market consumers, by increasing their spending power, said Paul Donovan, a global economist at UBS AG in London.
And emerging markets may only be swooning rather than slumping, with investors differentiating between them. The MSCI Emerging Markets Index last week logged its biggest weekly gain since September.
The danger is that the sub-par price performance begins to affect consumer and company psychology, convincing people that it’s better to put off spending today in hopes of even lower prices tomorrow.
‘Feedback Loop’I have long argued the titanic battle over deflation is the most important macroeconomic event of our time. I also argued that Fed tapering will lead to deflation and central banks have to be very careful not to stoke another crisis in emerging markets because this will reinforce deflationary headwinds around the world.
“If you’re a central bank targeting inflation and inflation does the opposite of what you want, then you have more pressure to act,” said Andrew Roberts, head of European rates strategy at Royal Bank of Scotland Group Plc. He sees a “feedback loop” between emerging market weakness and lower inflation elsewhere.
The ECB may have the most to worry about. Despite Draghi’s assurances, Barclays strategists say the euro area faces a bigger chance of Japanese-style deflation than investors or policy makers accept. ECB policy is looking too tight, budgets have been cut deeply and bank lending has yet to improve, they said in a report last week.
“The ECB is aware of the danger,” said Philippe Gudin, head of European economics research at Barclays in Paris. He predicts the bank will cut its 0.25 percent benchmark rate in March as well as its deposit rate, and may even begin quantitative easing at some point if the world suffers a shock such as a worsening emerging-markets crisis.
At the Fed, policy makers have been surprised by the ebbing price pressures. Excluding food and energy costs, the personal consumption expenditure price index rose 1.2 percent in 2013, matching 2009 as the smallest gain since 1955. Of 27 categories of goods and services in the gauge, 18 showed smaller price increases over the past two years, according to data compiled by Bloomberg.
Fed policy makers are forecasting inflation will rise to about 1.5 percent at the end of this year and gradually increase thereafter toward their 2 percent target.
It won’t measure up to those expectations, forcing the central bank to delay its first interest rate increase until early 2016, said Michael Hanson, a former Fed economist who is now senior U.S. economist for Bank of America in New York. Most policy makers expect to start raising rates next year, according to projections released in December.
“There’s a fair bit of disinflationary pressure out there globally,” Hanson said. “There’s a lot of excess capacity.”
And make no mistake, deflation is a central banker’s nightmare:
Stephen Poloz says he thinks deflation in Canada is “very unlikely” but he’s not ruling out the possibility. The Governor of the Bank of Canada is clearly worried about our low rate of inflation, 1.2 per cent in December, which he says is “underperforming all our models.”The New York Times opines Europe is flirting with deflation. The Telegraphs' Ambrose Evans-Pritchard writes France is looking straight down the barrel of a deflation shock. And according to a study by economists at Wells Fargo, the U.S. economy may prove more prone to deflation than the Federal Reserve acknowledges and that may present a reason to keep monetary policy loose:
Why should you care? Because deflation is a bad thing — in fact, it’s every central banker’s second-worst nightmare. (I’ll tell you what number one is later).
In a deflationary situation, the price of many goods and services falls. That may mean cheaper food, cheaper houses, cheaper haircuts, cheaper Maple Leafs tickets.
So what’s wrong with that? The danger is that the economy collapses into what is known as a deflationary spiral where prices keep falling. People stop buying everything but necessities because they believe they’ll pay less next week. Inventories build, output drops, layoffs accelerate, wages are cut and the economy slumps into recession or even depression.
As each dollar becomes worth more in purchasing power, the cost of carrying debt increases, putting more pressure on borrowers and governments. Meantime the value of real assets drops.