Why are the major central banks so paranoid about deflation? It’s probably because they are staffed (stuffed) with macroeconomists who associate deflation with depression. In their opinion, falling prices make it harder for debtors to service their debts. Widespread defaults on those debts could cause a financial crisis and a severe economic downturn. I believe their thinking is that simplistic.
Yet, perversely, the central banks have been responding to the risk of deflation with ultra-easy monetary policies in an effort to stimulate more debt-financed spending. It seems to be working in the US, though a significant portion of borrowing in recent years has been in the corporate bond market to finance stock buybacks. More recently, debt-financed M&A activity has picked up as well. Often, these deals are associated with cuts in payrolls.
On the other hand, debt is financing a US boom in multifamily housing construction and solid activity in commercial real estate. Mortgage-financed new and existing home sales also have continued to recover from the Great Recession. Auto loans are financing cyclical highs in auto sales.
US consumer price inflation measures excluding food and energy are closer to 2% than to zero. So the Fed is more relaxed about deflation and started raising interest rates again at the end of last year. However, Fed officials constantly and consistently say that the process of normalizing monetary policy will be very gradual.
In the Eurozone and Japan, both headline and core consumer inflation rates are close to zero, i.e., bordering on deflation. Ultra-easy money has failed to stimulate borrowing and demand in their economies. Both have been in growth recessions over the past few years. Since Q4-2010, real GDP is up 10.5% in the US but only 3.2% in the Eurozone and 2.7% in Japan.
The Chinese authorities don’t have a deflation problem as measured by their CPI. They do have one as measured by their PPI, which has been falling on a y/y basis for the past 51 months through May. They have been all too successful at pumping lots of credit through their banking system in the economy. Perversely, rather than fueling demand, much of it has financed more deflationary capacity expansion. China actually stands out as the one country where deflationary pressures may very well lead to lots of debt defaults and a severe downturn. However, easy money is exacerbating the problem rather than ameliorating it. Let’s dive into the widely feared sea of deflation and see what we can see:
(1) Durables deflation. There are seven countries that report the durable goods, nondurable goods, and services components of their CPIs. Here is what they’ve done since 1996:
Durables: US (-16.1%), Eurozone (-1.4), Japan (-50.1), Sweden (-31.1), Switzerland (-26.4), Taiwan (-28.9), and UK (-26.9).
Nondurables: US (51.1), Eurozone (37.1), Japan (9.1), Sweden (36.0), Switzerland (-13.7), Taiwan (51.0), and UK (37.7).
Services: US (73.7), Eurozone (48.3), Japan (5.8), Sweden (45.9), Switzerland (7.5), Taiwan (21.1), UK (96.3).
The pattern is obvious: There has been across-the-board deflation in durable goods, while nondurable goods and services have continued to inflate almost everywhere. The only difference recently (i.e., since mid-2014) is that energy prices have contributed deflationary pressures to the nondurable goods components. Durable goods deflation has been mostly good deflation, attributable to big gains in manufacturing productivity thanks to technological innovations. Weak demand hasn’t been the source of the deflation. On the contrary, durable goods deflation certainly has benefitted consumers around the world, lifting their purchasing power and standards of living.
(2) Inflating & deflating in the US. In the US, durable goods deflation has been widespread, though five of the remaining six countries have had more of it since 1996. The US has had the highest inflation in nondurable goods of the seven. It’s had the second-highest rate of services inflation.
Interestingly, the CPI inflation rate in the US has tended to exceed the PCED measure mostly because of their respective services components. In April, this component was up 2.7% in the CPI and 2.2% in the PCED. There has been a persistent gap between medical services in the CPI, currently up 3.1%, and in the PCED, up 1.3%. That’s because the former covers all out-of-pocket expenses, but does not include costs paid by government health care programs. The PCED covers both.
Furthermore, while rent inflation is measured identically in both the CPI and PCED, it has a much higher weight in the former (at 32%) than in the latter (at 15%). Rent has been among the categories with the highest (and rising) inflation rates during the current economic expansion.
(3) Yen devaluation fails to reflate. Among the most startling economic events since late 2012 has been the 38% depreciation of the yen through late 2015. The Japanese government implemented a stimulative program in 2013, widely known as “Abenomics,” that included massive QE by the BOJ. The aim clearly was to devalue the yen with the goal of ending deflation by boosting export volumes and import prices. It hasn’t worked. Exports did rebound for a short period, but during April were back down to the lowest pace since January 2014.
Inflation remains around zero. As shown above, Japan has had more durable goods deflation than other countries, and the least inflation in nondurables and services. In Japan’s case, weak demand certainly has contributed to overall deflationary pressures. Much of that can be attributed to the rapidly aging demographics of the country. There’s nothing the BOJ can do about that.
(4) Leak in ECB’s monetary pump. The ECB remains committed to providing more ultra-easy monetary policy to revive economic growth and inflation. Indeed, starting this month, the central bank will expand its QE program to include corporate bonds. Loans to the Eurozone’s private sector rose just 0.5% y/y through April, notwithstanding a 33% increase in the ECB’s balance sheet over this period and the introduction of negative interest rates on June 5, 2014. The problem may be that many borrowers borrowed too much during the previous decade’s boom, and don’t have the capacity to borrow more.
(5) Refinancing paradox. So why haven’t the historically low interest rates provided by the central banks revived growth and inflation? Too much accumulated debt stimulated by easy credit conditions in the past is weighing on demand. Aging demographics are also a drag on growth and inflation. Technological innovation is disruptive and inherently deflationary. Some deflation, especially in durable goods, should be welcomed as good inflation.
Most perverse is the likelihood that ultra-easy monetary policy has contributed to secular stagnation. It has allowed borrowers to refinance at lower rates. However, on balance, it seems that supply-side borrowers are benefitting more than demand-side borrowers. In other words, companies that might have been forced out of business or forced at least to reduce capacity continue to produce, hoping to sell to consumers who remain wary of borrowing more even at lower rates.
Of course, record-low interest rates may be forcing consumers to save more given the pathetic return on their assets. Furthermore, they have less income from their fixed-income portfolios to spend. This all adds up to persistent secular stagnation, with central banks continuing to provide easy monetary conditions in the hopes that their demand-side models will come back from the dead.