A falling dollar, steep yield curve, narrowing credit spreads and a rising stock market are all signs deflation is not a real problem in the US
Deflation is everywhere. References to it, that is. Yields on long-term Treasuries have collapsed, falling more than 50 basis points following the Federal Reserve's intimation on 6 May that inflation could be too low.
Judging from the ensuing discussion, inflation and deflation are apparently hard to define and more difficult to understand. Chronically falling prices of technology equipment are not deflation. Ever-escalating tuition and medical care costs don't constitute inflation.
Deflation (inflation) is a general fall (rise) in the price level associated with a fall (rise) in the stock of money. Jim Grant, editor of Grant's Interest Rate Observer, provides a superb primer on deflation in the 23 May issue. In it, Grant exposes the fallacies about deflation that have entered the vernacular. For example, 'falling prices are the fruits, or an effect, of deflation,' Grant writes. 'In the United States today, there is some of the effect but none of the cause. Some prices are falling (and, to be sure, some are rising), but no contraction in money or credit is evident.'
Let us go to the videotape. The broad monetary aggregate M2, which includes demand deposits, savings deposits, time deposits and retail money market funds in addition to currency, is up 8.1% in the year ended 12 May. On a 13-week annualised basis, M2 is growing at close to 9%.
Bank credit, which encompasses loans, leases and securities, is up 11.2% in the past year and 10.5% in the last 13 weeks.
There is a certain irony in the Fed's fanning the deflation flames since it is the one entity entrusted with preventing it.
The Fed did not always confuse causes and effects. The astute Joe Carson, an economist at Alliance Capital Management, unearthed this titbit from the transcripts of the Fed's 27 September 1994, meeting, evidence that at some point Fed Chairman Alan Greenspan thought money was the necessary ingredient for any inflation. 'We are approaching a point where we will get interesting tests as to whether inflation is a Phillips curve phenomenon or a monetary phenomenon,' Greenspan said.
Based on a Phillips-curve analysis, which posits a trade-off between inflation and unemployment, the absence of any slack in the industrial sector was suggestive of an economy 'on the edge of some severe inflationary pressure,' Greenspan said. 'If, however, we think that prices are a monetary phenomenon, we are more likely to see the types of changes that occurred prior to the 1930s where we had a non-inflationary long-term environment largely locked in by the gold standard, periods of significant pressure during which inflation never really took hold, because the credit aggregates never really took hold, as they couldn't in that type of environment.'
Greenspan was basically saying he has not gotten any clearer with nine more years in the job, that a lack of excess capacity cannot 'cause' inflation without the proper monetary tinder. Only the central bank can do that by fuelling demand for scarce resources.
As it turned out, inflation never accelerated as the already slow growth in M2 ground to a halt.
Why is this process so different in reverse? How can the Fed be worried about deflation when there is no hint of it in the money and credit data?
In the financial markets, the Fed's 6 May warning of the minor probability of an 'unwelcome substantial fall in inflation' dovetailed with two back-to-back months of no change in the consumer price index excluding food and energy. The core CPI is rising at 1.5% year over year, the slowest pace in four decades.
All of us extrapolate the CPI from our own experiences. For example, anyone buying a computer today for the first time in three years thinks prices are plummeting. If, on the other hand, you are like me and whatever you buy a) does not work right and b) requires endless phone calls to fix it, you will no doubt conclude that prices are rising under the doctrine that time is money.
Throw in all the over-investment of the 1990s and excess capacity the economy is left with today, and deflation rhetoric is in full bloom.
'Excess capacity, technological improvements and declining import prices are often cited as concrete sources of potential deflation,' Carson says. 'Deflation and inflation are purely monetary phenomena. They are not created solely by business conditions, but through the relationship between those business conditions and the concurrent monetary conditions.'
Urged on by the Fed, the bond market's willingness to adopt deflation as its MO can lead to some significant imbalances.
Not that market-based indicators are signaling deflation. To the contrary, a falling dollar, a steep yield curve, narrowing credit spreads and a rising stock market are all inconsistent with a forecast of deflation.
What's more, the spread between nominal and inflation-indexed Treasuries is forecasting low inflation, not deflation, of 1.7% over the next 10 years. The rally in the Treasury market, which took yields to 45-year lows, 'is not being driven by fears of deflation but by the perception that central bankers' awareness of the cost of deflation has altered the likely course of policy in the coming quarters,' says Lou Crandall, chief economist at Wrightson ICAP.
That message comes with a cost.
'With today's low funds rate, steep yield curve and expressed official anxiety about deflation, the welcome mat is out for leveraged speculation on even lower interest rates,' Grant writes.
An unnamed source Grant quotes put it best: 'At prevailing levels, Treasuries provide not risk-free return but return-free risk.'
Bloomberg newsroom, San Francisco
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