Deflation: Good vs. Bad. Bob Wiley, the anxiety-prone obsessive-compulsive character played by Bill Murray in “What About Bob?,” tells his psychiatrist, played by Richard Dreyfuss, “There are two types of people in this world: those who like Neil Diamond, and those who don’t.”
Previously, I’ve often argued that there are two kinds of deflation. In a period of good deflation, consumer prices fall as a result of competition, technological innovation, and productivity. Consumers’ purchasing power increases and they spend more, which results in more demand and more jobs. The standard of living improves.
Bad deflation typically occurs after a prolonged period of easy credit. The stimulative impact of easy credit is increasingly dampened by the burden of accumulated debt, which weighs on demand. Meanwhile, supply is plagued by too much capacity as easy money allows the living-dead “zombie” producers to stay in business. Zombies are very sociable. They create more zombies as profitable companies become unprofitable competing with them. Debt servicing becomes more onerous as the profits recession is exacerbated by falling prices. A dangerous deflationary spiral is often triggered by the bursting of speculative bubbles that had been inflated by easy money.
Today, we have a combination of low inflation with some good and some bad deflation. Debbie and I have found that seven countries around the world disaggregate their CPI inflation rates into indexes showing the prices of durable goods, nondurable goods, and services (Fig. 1). We can compare the seven since the start of 1996 through August of this year for all except Japan, which is through July. The CPI durable goods component is down for all seven as follows: Japan (-50.7%), Sweden (-31.4), Taiwan (-29.2), Switzerland (-27.3), UK (-27.1), US (-17.3), and Eurozone (-1.5).
Nondurable goods prices are up for six of the seven over this period: Taiwan (51.7%), US (51.5), UK (37.6), Eurozone (37.6), Sweden (36.3), and Japan (9.2); Switzerland fell 13.5% (Fig. 2). CPI services indexes are up in all of them: UK (98.5), US (75.7), Eurozone (49.1), Sweden (46.4), Taiwan (21.9), Switzerland (7.7), and Japan (5.8) (Fig. 3).
Clearly, this is a picture of mostly good deflation, with falling durable goods prices making these products more affordable for more people around the world. The producers of most of those goods are mostly profitable, as strong unit sales and lower unit costs (thanks to technology and productivity) more than offset the downward pressure on prices. Also offsetting the squeeze on profit margins are the constant improvements in durable goods, which boost demand for the versions and models with the latest bells and whistles.
The epicenter of bad deflation in recent years has been China. The country’s PPI has been falling on a y/y basis for the past 54 months through August (Fig. 4). That reflects excess capacity that has been sustained by the provision of easy money and other government measures providing life support for zombie producers in manufacturing. The good news is that the PPI inflation rate was -0.8% during August, the least negative since April 2012, suggesting that some progress is being made in reducing excess capacity in China.
The bad news is that bank credit continues to grow too rapidly in China. During the first eight months of this year, it is up $1.3 trillion compared to the same amount over the same period last year (Fig. 5). Bank loans outstanding have tripled to a record $15.5 trillion during August since April 2009 (Fig. 6). All of these loans have been internally financed, since M2 has actually increased faster than loans. Now consider the following:
(1) Chinese fiscal policy. Bloomberg included a 9/18 article titled “China Expected to Keep Its Deep Pockets Open to Boost Its Economy.” The gist of the story was: “China is seen keeping its deep pockets open in the second half and through 2017, despite having front-loaded spending earlier this year, as fiscal policy takes over from broad monetary easing as the major prop to growth. The central government’s fiscal deficit will surpass the target of 3 percent of gross domestic product set for 2016, according to economists surveyed by Bloomberg News.”
(2) Risk of Chinese financial crises increases. Yesterday’s FT reported: “China’s debt has grown to alarming levels, according to new data from the Bank for International Settlements that highlight a big potential risk to the global economy. What the BIS terms the country’s ‘credit gap’ is now three times higher than the typical danger level, the research shows. The measure tracks the difference between corporate and household debt as a proportion of gross domestic product and the long term trend, thus highlighting any divergence between current and historic borrowing patterns–a possible indicator of unsustainable debt accumulation. The BIS rates a reading above 10 per cent as cause for concern; China’s gap hit 30.1 per cent in March. According to the BIS, which is often dubbed the central bank’s central bank, the credit gap benchmark ‘has been found to be a useful early warning indicator of financial crises’.”
Inflation: Healthy vs. Unhealthy. There are also two kinds of inflation. There’s the kind that stimulates demand by prompting consumers to buy goods and services before their prices move still higher. The other kind of inflation reduces the purchasing power of consumers when prices rise faster than wages. That variety of inflation certainly doesn’t augur well for consumer spending.
During the 1960s and 1970s, price inflation rose faster than interest rates. The Fed was behind the inflationary curve. So were the Bond Vigilantes. However, wages kept pace with prices because unions were more powerful than they are today, and labor contracts included cost-of-living adjustments. Back then, the University of Michigan Consumer Sentiment Survey tracked rising “buy-in-advance” attitudes. Those attitudes remained particularly strong in the housing market through the middle of the previous decade. On balance, inflation stimulated demand more than weighed on it. Borrowing was also stimulated.
Today, the major central banks would like to revive buy-in-advance attitudes, along with inflationary expectations, to boost demand for goods and services. For various reasons, the central bankers have failed to increase their inflation measures back up to their 2% targets. Despite several years of ultra-easy monetary policy since the financial crisis of 2008, the ECB’s preferred measure (i.e., the headline CPI) has been under 2% since February 2013, and was up only 0.2% y/y through August (Fig. 7). The BOJ’s preferred inflation measure (i.e., “core” inflation excluding only food) has been under 2% since April 2015, and was 0.5% through July (Fig. 8).
In the US, there is some confusion about whether Fed officials are targeting the headline or the core PCED inflation rate (Fig. 9). In the past, they all seemed to focus on the core rate excluding food and energy. More recently, even individual FOMC participants have mentioned both as worth monitoring. In any event, both remain below the Fed’s 2% target, with the headline at 0.8% and the core at 1.6%.
A few Fed officials believe that the core is close enough to 2% to hike the federal funds rate again soon. Others say that having stayed stubbornly below 2% for most of the time since October 2008, what’s the rush to raise rates? Tomorrow afternoon, we will all find out whether the doves or the hawks won the debate at the latest meeting of the FOMC.
Both sides are missing an important development on the inflation front. The variety of inflation that the US is experiencing isn’t the kind that stimulates economic growth. On the contrary, it has been led by rising rents, and more recently by rising health care costs. It is very unlikely that buy-in-advance attitudes cause people to rent today because rents will be higher tomorrow, or to rush to the hospital to get a triple-bypass today because it will be more expensive tomorrow! Higher shelter and health care costs are akin to tax increases because they reduce the purchasing power available for other goods and services. Consider the following:
(1) The rent is too d@mn high! Tenant rent accounts for 5% of the core PCED and 10% of the core CPI. In August, it was up 3.8% y/y in the CPI, well ahead of the increase in the core rate (Fig. 10). That can’t be good for consumers’ purchasing power given that a record 37% of all households were renters during Q2-2016 (Fig. 11). The tenant-rent data are used to construct owners’ equivalent rent (a very strange concept, indeed!), which accounts for 13% of the core PCED and 31% of the core CPI. It was up 3.3% y/y during August, the highest pace since June 2007 (Fig. 12). Why would anyone at the Fed think that’s a happy development, since it doesn’t really have any effect one way or the other on anyone, because what homeowners rent their homes from themselves!?
(2) Obamacare’s stealth mission almost accomplished. Of course, 100% of households rely on our health care system. August’s CPI had some really bad news on this front. There were big increases in health care prices as the overall health care index jumped 1.0% m/m (the most since February 1984) and 4.9% y/y (the highest since January 2008) (Fig. 13).
It’s not clear why the surge occurred during August, but it may be related to the expansion of healthcare coverage under Obamacare. There has certainly been an increase among the population with pre-existing conditions, which has significantly boosted costs for all. Many conservatives always suspected that Obamacare was designed to fail so that the government would have to save the day with a nationalized single-payer system.
By the way, one of the main reasons that the CPI inflation rate exceeds the PCED rate is because the latter doesn’t include health care spending paid for by the government through Medicaid and Medicare. Nevertheless, when August’s PCED is released on September 30, it may very well hit the Fed’s 2% target thanks to rapidly rising rents and health care costs. For the man and woman on the street, congratulations to the Fed will not be in order. However, we wouldn’t be surprised if Fed officials jubilantly declare: “Mission accomplished!”