Friday, November 14, 2014

Is Deflation Coming to America?

John Cochrane, professor of finance at the University of Chicago Booth School of Business, wrote an op-ed for the Wall Street Journal, Who's Afraid of a Little Deflation?:
With European inflation declining to 0.3%, and U.S. inflation slowing, a specter now haunts the Western world. Deflation, the Economist recently proclaimed, is a “pernicious threat” and “the world’s biggest economic problem.” Christine Lagarde , managing director of the International Monetary Fund, called deflation an “ogre” that could “prove disastrous for the recovery.”

True, a sudden, large and sharp collapse in prices, such as occurred in the early 1920s and 1930s, would be a problem: Debtors might fail, some prices and wages might not adjust quickly enough. But these deflations resulted directly from financial panics, when central banks couldn’t or didn’t accommodate a sudden demand for money.

The worry today is a slow slide toward falling prices, maybe 1% to 2% annually, with perpetually near-zero short-term interest rates. This scenario would unfold alongside positive, if sluggish, growth, ample money and low credit spreads, with financial panic long passed. And slight deflation has advantages. Milton Friedman long ago recognized slight deflation as the “optimal” monetary policy, since people and businesses can hold lots of cash without worrying about it losing value. So why do people think deflation, by itself, is a big problem?

1) Sticky wages. A common story is that employers are loath to cut wages, so deflation can make labor artificially expensive. With product prices falling and wages too high, employers will cut back or close down.

Sticky wages would be a problem for a sharp 20% deflation. But not for steady 2% deflation. A typical worker’s earnings rise around 2% a year as he or she gains experience, and another 1%—hopefully more—from aggregate productivity growth. So there could be 3% deflation before a typical worker would have to take a wage cut. And the typical worker also changes jobs, and wages, every 4½ years. Moreover, “typical” is the middle of a highly volatile distribution of wage changes among a churning job market. Ultimately very few additional workers would have to take nominal wage cuts to accommodate 2% deflation.

Curiously, if sticky wages are the central problem, why do we not hear any loud cries to unstick wages: lower minimum wages, less unionization, less judicial meddling in wages such as comparable worth and disparate-impact discrimination suits, fewer occupational licenses and so forth?

2) Monetary policy headroom. The Federal Reserve wants a 2% inflation rate. That’s because with “normal” 4% interest rates, the Fed will have some room to lower interest rates when it wants to stimulate the economy. This is like the argument that you should wear shoes two sizes too small, because it feels so good to take them off at night.

The weight you put on this argument depends on how much good rather than mischief you think the Fed has achieved by raising and lowering interest rates, and to what extent other measures like quantitative easing can substitute when rates are stuck at zero. In any case, establishing some headroom for stimulation in the next recession is not a big problem today.

3) Debt payments. The story here is that deflation will push debtors, and indebted governments especially, to default, causing financial crises. When prices fall unexpectedly, profits and tax revenues fall. Costs also fall, but required debt payments do not fall.

Again, a sudden, unexpected 20% deflation is one thing, but a slow slide to 2% deflation is quite another. A 100% debt-to-GDP ratio is, after a year of unexpected 2% deflation, a 102% debt-to-GDP ratio. You’d have to go decades like this before deflation causes a debt crisis.

Strangely, in the next breath deflation worriers tell governments to deliberately borrow lots of money and spend it on stimulus. This was the centerpiece of the IMF’s October World Economic Outlook antideflation advice. The IMF at least seemed to realize this apparent inconsistency, claiming that spending would be so immensely stimulative that it would pay for itself.

4) Deflation spiral. Keynesians have been warning of a “deflation spiral” since Japanese interest rates hit zero two decades ago. Here’s the story: Deflation with zero interest is the same thing as a high interest rate with moderate inflation: holding either money or zero-interest rate bonds, you can buy more next year. This incentive stymies “demand,” as people postpone consumption. Falling demand causes output to fall, more deflation, and the economy spirals downward.

It never happened. Nowhere, ever, has an economy such as ours or Europe’s, with fiat money, an interest-rate target, massive excess bank reserves and outstanding government debt, experienced the dreaded deflation spiral. Not even Japan, though it has had near-zero inflation for two decades, experienced the predicted spiral.

There are good reasons to believe it can’t happen. Most of all, government solvency fears that don’t matter for 2% deflation kick in and stop a deflation spiral. If prices fall 20%, or 30%, bond-holders will see that governments cannot pay back debts. They try to get rid of their bonds before the coming default. They buy things or other currencies, nipping the deflation spiral in the bud.

There is an unsettling feature of the current inflation situation, however. Clearly, our central banks want higher inflation, and the current slow decline was unintended. So, just as clearly, central banks have a lot less understanding of and control over inflation and deflation than most people think.

According to the conventional worldview, the economy is inherently unstable. Central banks control inflation the way you balance an upside-down broom, with interest rates on the bottom and inflation on top. Central banks have to actively move interest rates around to keep inflation and deflation from breaking out. And if they want more inflation, they must temporarily move interest rates the wrong way, let the inflation increase, and then move quickly to stabilize it.

Hence the zero-bound worry. When interest rates hit zero and the Fed can’t move the broom handle any more, the top of the broom must topple into deflation. Except we hit the zero bound, and almost nothing happened. Maybe the economy isn’t so inherently unstable and in need of constant guidance after all.

Bottom line? Relax. Every few months we hear a new “biggest economic problem” from which our “policy makers” must save us. Wait for the next one.
This is an excellent article written by a Chicago school economist. Their economists have a long tradition of arguing the economy is not inherently unstable, and left to its own devices, it will find a proper market equilibrium. And he's right, if unemployment stays at current levels, a little deflation is nothing to worry about.

But what if it's not a little but a lot of deflation? According to Albert Edwards, a yen crash will send a deflationary tidal wave to the West:
Société Générale strategist Albert Edwards is predicting a yen crash will force devaluations across Asia, which will have significant repercussions for the West.

In the perma-bear's view the market has not 'grasped the significance of this phase of currency wars'.

'It reminds me of the 2006/07 period when falling US house prices and then widening corporate bond spreads were totally ignored by upbeat equity investors until it was too late,' he reflected.

In his view, the yen is set to follow the US dollar DXY trade-weighted index 'by crashing through multi-decade resistance - around ¥120'. Once the dollar-yen exchange rate reaches this level, he expects a very quick ¥25 move to ¥145.

'I expect the key ¥120/$ support level to be broken soon and the lows of June 2007 (¥124) and February 2002 (¥135) to be rapidly taken out,' he noted.

This, he expects, will force devaluations across the whole Asian region and will send a tidal wave of deflation westwards.

'I simply think Japan will lose control of the situation given the quantity of quantitative (QE) being spewed into the markets and unless the US, the eurozone, or indeed Korea, is prepared to come remotely close to Japan’'s rate of QE, jawboning currency stability will do very little,' Edwards explained.

'But I do believe the yen devaluation will drag down other competing currencies in the Asian region,' he added - not least China.

He points to 32 successive months of deflation in China at the producer price level and poses the question: do investors think China can cope with a devaluation of the yen from here?

He answered: 'They simply can’t tolerate this and they won’t. They will devalue.'

He points out that strategists are rarely willing to make bold currency forecasts and therefore do not tend to predict too far from the current spot rate.

'It is mainly the fear of being wrong that prevents them from making bold forecasts, despite consistent evidence that markets are far more volatile than their mundane forecasts ever suggest,' he added.

While Japan is cheap and getting cheaper, he anticipates further dollar strength ahead too.

Edwards is not a strong believer in quantitative easing (QE) in terms of Bernanke's former approach of pushing up asset prices to inflate the real economy.

Yet he believes the only way that QE works is via the exchange rate and commends the Bank of Japan for genuinely doing whatever it takes. This contrasts starkly with the European Central Bank, he comments.

'The problem for the eurozone is that Draghi is getting increasingly long on promises and pretty disappointing on delivery. Japan is just on a different page, league, or indeed planet, altogether,' he added.

He anticipates the yen could fall to the July 08 low of ¥170 versus the euro.
Edwards is highlighting important macroeconomic linkages that investors are ignoring. The sharp drop in the yen has profound implications for Asian economies struggling with their own deflation demons.

And the biggest economy in the region is China which according to the Economist, is now skirting close to outright falls in prices across a wide swathe of the economy:
Inflation data published on Monday provide the latest evidence of China’s descent towards deflation. The consumer price index (CPI) rose 1.6% in October from a year earlier, the lowest since the start of 2010. Month-on-month CPI inflation was flat, falling back from September’s 0.5% increase. Core inflation, stripping out volatile food and energy prices, ticked down to 1.4% year-on-year in October, below the 1.7% average over the previous nine months. Meanwhile, the producer price index (PPI) ran deeper into negative territory. Prices of goods as they left factory gates fell 2.2% in October from a year earlier, steeper than the 1.8% decline in September. PPI has been in deflation for 32 straight months.
And Chriss Street of Breitbart is right, if deflation takes hold in China, it will crush Europe at the worst time as it will be importing Chinese deflation:
With producer prices in China declining for nearly three years, the European Union as China’s biggest trading partner has been importing deflation. But with Chinese deflation accelerating, Europe seems doomed to suffer a deflationary crash as consumers delay purchases, companies cancel investments, and workers suffer rising layoffs.

Inflation data published on Monday for the month of October reveals China’s rapid descent towards actual deflation as the consumer price index (CPI) rose just 1.6% from a year ago. The annual reading was the lowest rate since 2010 and flat from the prior month. Subtracting out the volatile food and energy components, Chinese “core inflation” plunged in October to a negative at -1.4% versus a year ago.

After growing from virtually zero two decades ago, the European Union is China’s biggest trading partner. The EU exports about $350 million of goods and services a day but imports $750 million per day from China. The result is a net trade deficit of about $350 million per day. Any change in China export prices are quickly felt in the EU.

Producer Price Index (PPI) for goods leaving Chinese factory gates fell from a negative -1.8% in September to a negative -2.2% in October. The accelerating decline in prices caps a string of 32 straight months of deflating prices.

Falling PPI would normally be a sign that a nation’s interest rates are too high and monetary policy too tight, but the price decline is due to commodity prices that have been plummeting since May of 2012 and are now below the crisis levels at the depth of the 2008 financial crash. As a resource poor nation, monetary stimulation and lower interest rates would little impact reducing falling goods prices. 

China’s strong export surplus with the EU and others has meant that the domestic labor market has remained tight. While average worker wages in China increased by 9.3% in the first nine months of 2014, EU wages were only up by +1%. Labor demand also explains why average youth unemployment in the EU was 18.1% and only 7.4% in China, according to the International Labour report for 2012.

The European Union officially estimated the current inflation rate is +.04% annually, despite the EU targeting a positive +2% rate. Many analysts including Boskin Commission Report,  Hausman’s Journal of Economic Perspectives surveyRobert Gordon, and Mark Wynne believe that EU inflation is positively overstated by  a +0.7% to +2.2%. Such an adjustment would mean the EU is already in serious deflation.

The International Monetary Fund's latest world economic outlook (WEO) raised the probability of deflation in the Eurozone over the next six months from 20% earlier this year to 30%. But with the huge flow of deflated Chinese goods in transit to the EU, the probability of the EU officially being in deflation would seem to be much higher.   
Then-U.S. Federal Reserve Chairman Ben Bernanke opined in 2002 that “sustained deflation can be highly destructive to a modern economy and should be strongly resisted.” Current Chairwoman Janet Yellen shared his concerns in a 2009 speech: “It is conceivable that this very low inflation could turn into outright deflation. Worse still, if deflation were to intensify, we could find ourselves in a devastating spiral in which prices fall at an ever-faster pace and economic activity sinks more and more.”

What economists fear about deflation is not that prices get cheaper, but rather that the expectation of cheaper prices will cause consumers to delay purchases and stimulate employers to cut back production and lay-off workers.

What European social welfare states fear most about deflation is that their tax systems are designed to use inflation combined with progressive income tax rates as a tool to accelerate wealth redistribution from the people to the state. Deflation would reverse that process as tax collections will wither faster than the economy slows.

With the European Union already near zero growth, despite what most economist believe is a substantial overstatement of inflation, Chinese deflationary exports in transit seem sure to push the European Union into deflation.
Indeed, Europe is already spiraling into deflation, and if Chinese deflation gets worse and they are forced to devalue the yuan, it will flood their economies with cheap imports, exacerbating the euro deflation crisis at the worst possible time.

Nobody has argued more clearly about the threat of deflation than the Telegraph's Ambrose-Evans Pritchard. In his latest comment, he warns that spreading deflation across East Asia threatens fresh debt crisis (click on images to enlarge):
Deflation is becoming lodged in all the economic strongholds of East Asia. It is happening faster and going deeper than almost anybody expected just months ago, and is likely to find its way to Europe through currency warfare in short order.

Factory gate prices are falling in China, Korea, Thailand, the Philippines, Taiwan and Singapore. Some 82pc of the items in the producer price basket are deflating in China. The figures is 90pc in Thailand, and 97pc in Singapore. These include machinery, telecommunications, and electrical equipment, as well as commodities.

Chetan Ahya from Morgan Stanley says deflationary forces are “getting entrenched” across much of Asia. This risks a “rapid worsening of the debt dynamic” for a string of countries that allowed their debt ratios to reach record highs during the era of Fed largesse. Debt levels for the region as a whole (ex-Japan) have jumped from 147pc to 207pc of GDP in six years.

These countries face a Sisyphean Task. They are trying to deleverage, but the slowdown in nominal GDP caused by falling inflation is always one step ahead of them. “Debt to GDP has risen despite these efforts,” he said. If this sounds familiar, it should be. It is exactly what is happening in Italy, France, the Netherlands, and much of the eurozone.

Data from Nomura show that the composite PPI index for the whole of emerging Asia – including India – turned negative in September. This was before the Bank of Japan sent a further deflationary impulse through the region by driving down the yen, and before the latest downward lurch in Brent crude prices.

The Japanese know what it is like to be on the receiving end. A recent study by Naohisa Hirakata and Yuto Iwasaki from the Bank of Japan suggests that China’s weak-yuan policy - a polite way of saying currency manipulation to gain export share – was the chief cause of Japan’s deflation crisis over its two Lost Decades.

The tables are now turned. China itself is now one shock away from a deflation trap. Chinese PPI has been negative for 32 months as the economy grapples with overcapacity in everything from steel, cement, glass, chemicals, and shipbuilding, to solar panels. It dropped to minus 2.2pc in October.

The sheer scale of over-investment is epic. The country funnelled $5 trillion into new plant and fixed capital last year - as much as Europe and the US combined - even after the Communist Party vowed to clear away excess capacity in its Third Plenum reforms. Old habits die hard.

Consumer prices are starting to track factory prices with a long delay. Headline inflation dropped to 1.6pc in October. This is so far below the 3.5pc target of the People’s Bank of China that it looks increasingly like a policy mistake. Core inflation is down to 1.4pc.

China has flirted with deflation before: during its banking crisis in the late 1990s, and again during the West’s dotcom recession from 2001-2002. Both episodes proved manageable.

This time the level of debt greater by orders of magnitude, with a large chunk in trusts, wealth product, and other parts of the shadow banking nexus, and a further $1.2 trillion in “carry trade” loans from Hong Kong. Standard Chartered thinks total debt has reached 250pc of GDP. This is roughly $26 trillion, the same size as the US and Japanese commercial banking systems put together, and therefore a headache for us all.

Larry Brainard from Trusted Sources says China is sliding towards a European debt-compound trap. “It’s arithmetic. Deflation will kill you if you’re leveraged. It is just a question of how quickly. We don’t know how big the problem is because China is playing a game of three-card Monte and moving the debt to different buckets,” he said.

“The bottom line is that PPI deflation increases the cost of leverage across the board. The risk is that it sets off a self-reinforcing cycle of debt defaults and rising non-performing loans that runs out of the control of the authorities. China will have to cut rates,” he said.

Asia is not yet in a full-blown currency war, but no country can stand idly by as neighbours dump toxic deflationary waste on their front lawn. Korea has threatened to force down the won, pari passu with the yen. The central bank of Taiwan has been intervening.

These skirmishes are happening in a region of festering grievances and territorial disputes, with no Nato-style security structure - or for that matter EU-style soft governance - to damp down fires. The spokes of the diplomatic wheel connect by a perverse geography to Washington, a city retreating from Pax Americana.

The Asia-Pacific Economic Cooperation summit this week feigned concord, but was in reality more like the Great Power dances of the late 1930s. China’s Xi Jinping shook nationalist hands with Japan’s Shinzo Abe, even as both sides rearm, and their warships threaten each other daily in Senkaku waters. In such a world - mercantilist by temperament in any case - attempts to export deflation to neighbours take on a sharper edge.

China has so far held its nerve under premier Li Keqiang, a man determined to wean his country off credit and an obsolete development model before it lurches into the middle income trap. It has not resorted to another blitz of stimulus - beyond short-term liquidity shots - even though house prices have been falling for five months and growth has fizzled. Fathom’s momentum tracker suggests that underlying GDP growth has dropped to 5pc.

The benchmark one-year lending rate is still 6pc. The reserve requirement ratio for banks is still 20pc. Money is getting tighter and tighter.

Nor has China intervened to hold down the yuan. Purchases of foreign bonds have dropped to zero, down from $35bn a month at the start of the year. The yuan has appreciated 22pc against the yen since June, and 50pc since mid-2012. It is up 12pc against the euro since the early summer.

China is in effect strapped to the rocketing dollar through its quasi-peg, increasingly a torture machine. George Magnus from UBS says this cannot continue. “What is happening in the property market is the tip of the iceberg for the whole economy. China will have to resort to monetary reflation over the winter, and I think this will include a lower yuan. We are heading into a currency war,” he said.

This looks all too like a replay the East Asia storm of 1998, when a tumbling yen triggered a Chinese banking bust and pushed Beijing to the brink of devaluation. Washington defused the crisis by stabilizing the yen, and by promising China membership of the World Trade Organisation.

It will be harder to repeat that trick in these deflationary times. The clear danger is that China will feel compelled to defend itself, throwing its huge weight into a beggar-thy-neighbour battle across East Asia.

Should that happen, the mother of all deflationary shocks will roll over Europe before the EU authorities have even got out of bed.
And as I've argued, if the mother of all deflationary shocks rolls over Europe and China, it's only a matter of time before it spreads to North America and this will crush investors underestimating the "new" risk of deflation.

I know, economists will tell you the drop in oil and commodity prices is "unambiguously good" as it will stimulate global demand. I beg to differ. I think the drop in oil and commodity prices is a harbinger of a serious global deflationary shock and international investors are starting to wake up to it, fearing darker days ahead.

Below, Landry’s Inc. Chief Executive Officer Tilman Fertitta talks about the U.S. commercial real-estate market, the impact of inflation on businesses and consumers, and the labor market and hiring. Fertitta, speaking with Stephanie Ruhle and Erik Schatzker on Bloomberg Television's "Market Makers, warns of 'huge inflation' and a 'real estate crash'. He got half of that right.

Second, John Mauldin, best-selling author and chairman of Mauldin Economics warns the U.S. dollar will "get a lot stronger than anyone can imagine". He's right, the mighty greenback is a huge story with big implications, the biggest of which is that it will reinforce deflationary headwinds in the U.S. and weigh down commodity and energy prices.

Lastly, Martin Feldstein, Harvard economics professor, explains why financial risk-taking worries him and provides insight on jobs, the economy and Fed policy. It worries me too and I think the next financial crisis will crush many public and private pension plans.

Once again, I ask all of you, especially institutional investors, to tip or subscribe to my blog and support my efforts via your financial contributions (go to PayPal buttons on top right-hand side). For those of you who are into cultural porn, read the latest on Kim Kardashian and her much twitted about butt here. As you can see, cultural deflation has already hit America (we've hit rock bottom).

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