Get Ready For 'Stag-Deflation'
Nouriel Roubini 10.30.08, 12:01 AM ET
Back in January, I argued that four major forces would lead to a risk of deflation-- or "stag-deflation," where a recession would be associated with deflationary forces--rather than the inflation that mainstream analysts have worried about.
They were: (1) a slack in goods markets, (2) a re-coupling of the rest of the world with the U.S. recession, (3) a slack in labor markets, and (4) a sharp fall in commodity prices following such U.S. and global contraction, which would reduce inflationary forces and lead to deflationary forces in the global economy.
How has such argument fared over time? And will the U.S. and global economies soon face sharp deflationary pressures? The answer: Deflation and stag-deflation will, in six months, become the main concern of policy authorities.
Why?
First, the U.S. has entered a severe recession that is already leading to deflationary forces in sectors where supply vastly exceeds demand (housing, consumer durables, motor vehicles, etc.). Aggregate demand is falling sharply below aggregate supply. The unemployment rate is up sharply, while employment has been falling for 10 months in a row. And commodity prices are sharply down--about 30% from their July peak--in the last three months, and are likely to fall much more in the next few months as the advanced economies' recession goes global. So both in the U.S. and in other advanced economies we are clearly headed toward a collapse of headline and core inflation.
Is there any doubt about this ongoing inflation capitulation and the beginning of sharp deflationary forces? Take the current views of the economic research group at JPMorgan Chase. This group was, in 2007-08, the leading voice arguing about the risks of rising global inflation and the associated risks of a global growth reflation, and that policy rates would be sharply increased in 2008-09.
This week, however, the JPMorgan research group published its latest global economic outlook, arguing that we are headed toward a global recession, negative global inflation and sharply lower policy rates in the U.S. and advanced economies--a 180-degree turn from its previous position. What a difference a year makes!
Do you have any further doubt that we're headed toward a global deflation or--better--a global stag-deflation? Read on: Aggregate demand is now collapsing in the U.S. and advanced economies, and sharply decelerating in emerging markets. There is a huge excess capacity for the production of manufactured goods in the global economy, as the massive, and excessive, capital expenditure in China and Asia (Chinese real investment is now close to 50% of gross domestic product) has created an excess supply of goods that will remain unsold as global aggregate demand falls.
Commodity prices are in free fall, with oil prices alone down over 50% from their July peak (and the Baltic Freight Index--the best measure of international shipping costs--is 90% down from its peak in May). Finally, labor market slack is sharply rising in the U.S., and rising, as well, in Europe and other advanced economies.
Next question: What are financial markets telling us about the risks of stag-deflation?
First, yields on 10-year Treasury bonds have fallen by about 50 basis points since Oct. 14, getting close to their previous 2008 lows. Also, the two-year Treasury yield has fallen by about 150 basis points in the last month.
Second, gold prices--a typical hedge against rising global inflation--are now sharply falling.
Finally, and more important, yields on Treasury Inflation-Protected Securities (TIPS) due in five years or less have now become higher than yields on conventional Treasuries of similar maturity. The difference between yields on five-year Treasuries and five-year TIPS, known as the break-even rate, fell to minus 0.43 percentage points.
This is a record. Since the difference between the conventional Treasuries and TIPS is a proxy for expected inflation, the TIPS market is now signaling that investors expect inflation to be negative over the next five years, as a severe recession is ahead of us.
So goods, labor, commodity, financial and bond markets are all sending the same message: Stagnation/recession and deflation (or stag-deflation) is ahead of us.
Don't be surprised, then, if six months from now the Fed and other central banks in advanced economies will start to worry--as they did in 2002-03 after the 2001 recession--about deflation rather than inflation. In those years, when the U.S. experienced a deflation scare, Fed Chairman Ben Bernanke wrote several pieces explaining how the U.S. could resort to very unorthodox policy actions to prevent a deflation and a liquidity trap like the one experienced by Japan in the 1990s. Those writings may, very soon, have to be carefully read and studied again.
Finally, while in the short run a global recession will be associated with deflationary forces, some ask whether we should worry about rising inflation in the middle run? This argument--that the financial crisis will eventually lead to inflation--is based on the view that governments will be tempted to monetize the fiscal costs of bailing out the financial system, and that this sharp growth in the monetary base will eventually cause high inflation.
In a variant of the same argument, some posit that--as the U.S. and other economies face debt deflation--it would make sense to reduce the debt burden of borrowers (households and, now, governments taking on their balance sheets the losses of the private sector) by wiping out the real value of such nominal debt with inflation.
So should we worry that this financial crisis and its fiscal costs will eventually lead to higher inflation? The answer to this complex question: likely not.
First, the massive injection of liquidity in the financial system--literally trillions of dollars in the last few months--is not inflationary, as it accommodates the demand for liquidity that the current financial crisis and investors' panic have triggered. Thus, once the panic recedes and this excess demand for liquidity shrinks, central banks can and will mop up all this excess liquidity.
Second, the fiscal costs of bailing out financial institutions would eventually lead to inflation if the increased budget deficits associated with this bailout were to be monetized, as opposed to financed with a larger stock of public debt. As long as such deficits are financed with debt--rather than by the printing presses--such fiscal costs will not be inflationary, as taxes will have to be increased over the next few decades and/or government spending reduced to service this large increase in the stock of public debt.
Third, to the question raised earlier: Wouldn't central banks be tempted to monetize these fiscal costs--rather than allow a mushrooming of public debt--and thus wipe out with inflation these fiscal costs of bailing out lenders/investors and borrowers? Not likely in my view. Even a relatively dovish Bernanke Fed cannot afford to let the inflation-expectations genie out of the bottle via a monetization of the fiscal bailout costs. It cannot afford to do that because a rise in inflation expectations will eventually force a nasty and severely recessionary Volcker-style monetary-policy tightening to get the genie back into its bottle.
Fourth, inflation can reduce the real value of debts as long as it is unexpected, and as long as debt is in the form of long-term nominal fixed-rate liabilities. An attempt to increase inflation would not be unexpected: Investors would write debt contracts to hedge against such a risk if monetization of the fiscal deficits does occur.
Also, in the U.S. economy, a lot of debts--of the government, of the banks, of the households--are not long-term nominal fixed-rate liabilities. They are, rather, shorter-term variable-rate debts. Thus, a rise in inflation in an attempt to wipe out debt liabilities would lead to a rapid repricing of such shorter term, variable-rate debt. And thus expected inflation would not succeed in reducing the part of the debts that are now of the long-term nominal fixed-rate form--i.e., you can fool all of the people some of the time (unexpected inflation) and some of the people all of the time (those with long-term nominal fixed-rate claims), but you cannot fool all of the people all of the time.
In conclusion, a sharp slack in goods, labor and commodity markets will lead to global deflationary trends over the next year. And the fiscal costs of bailing out borrowers and/or lenders/investors will not be inflationary, as central banks will not be willing to incur the costs of very high inflation as a way to reduce the real value of the debt burdens of governments and distressed borrowers. The costs of rising expected inflation will be much higher than the benefits of using the inflation tax to pay for the fiscal costs of cleaning up the mess that this most severe financial crisis has created.
Back in January, I argued that four major forces would lead to a risk of deflation-- or "stag-deflation," where a recession would be associated with deflationary forces--rather than the inflation that mainstream analysts have worried about.
They were: (1) a slack in goods markets, (2) a re-coupling of the rest of the world with the U.S. recession, (3) a slack in labor markets, and (4) a sharp fall in commodity prices following such U.S. and global contraction, which would reduce inflationary forces and lead to deflationary forces in the global economy.
How has such argument fared over time? And will the U.S. and global economies soon face sharp deflationary pressures? The answer: Deflation and stag-deflation will, in six months, become the main concern of policy authorities.
Why?
First, the U.S. has entered a severe recession that is already leading to deflationary forces in sectors where supply vastly exceeds demand (housing, consumer durables, motor vehicles, etc.). Aggregate demand is falling sharply below aggregate supply. The unemployment rate is up sharply, while employment has been falling for 10 months in a row. And commodity prices are sharply down--about 30% from their July peak--in the last three months, and are likely to fall much more in the next few months as the advanced economies' recession goes global. So both in the U.S. and in other advanced economies we are clearly headed toward a collapse of headline and core inflation.
Is there any doubt about this ongoing inflation capitulation and the beginning of sharp deflationary forces? Take the current views of the economic research group at JPMorgan Chase. This group was, in 2007-08, the leading voice arguing about the risks of rising global inflation and the associated risks of a global growth reflation, and that policy rates would be sharply increased in 2008-09.
This week, however, the JPMorgan research group published its latest global economic outlook, arguing that we are headed toward a global recession, negative global inflation and sharply lower policy rates in the U.S. and advanced economies--a 180-degree turn from its previous position. What a difference a year makes!
Do you have any further doubt that we're headed toward a global deflation or--better--a global stag-deflation? Read on: Aggregate demand is now collapsing in the U.S. and advanced economies, and sharply decelerating in emerging markets. There is a huge excess capacity for the production of manufactured goods in the global economy, as the massive, and excessive, capital expenditure in China and Asia (Chinese real investment is now close to 50% of gross domestic product) has created an excess supply of goods that will remain unsold as global aggregate demand falls.
Commodity prices are in free fall, with oil prices alone down over 50% from their July peak (and the Baltic Freight Index--the best measure of international shipping costs--is 90% down from its peak in May). Finally, labor market slack is sharply rising in the U.S., and rising, as well, in Europe and other advanced economies.
Next question: What are financial markets telling us about the risks of stag-deflation?
First, yields on 10-year Treasury bonds have fallen by about 50 basis points since Oct. 14, getting close to their previous 2008 lows. Also, the two-year Treasury yield has fallen by about 150 basis points in the last month.
Second, gold prices--a typical hedge against rising global inflation--are now sharply falling.
Finally, and more important, yields on Treasury Inflation-Protected Securities (TIPS) due in five years or less have now become higher than yields on conventional Treasuries of similar maturity. The difference between yields on five-year Treasuries and five-year TIPS, known as the break-even rate, fell to minus 0.43 percentage points.
This is a record. Since the difference between the conventional Treasuries and TIPS is a proxy for expected inflation, the TIPS market is now signaling that investors expect inflation to be negative over the next five years, as a severe recession is ahead of us.
So goods, labor, commodity, financial and bond markets are all sending the same message: Stagnation/recession and deflation (or stag-deflation) is ahead of us.
Don't be surprised, then, if six months from now the Fed and other central banks in advanced economies will start to worry--as they did in 2002-03 after the 2001 recession--about deflation rather than inflation. In those years, when the U.S. experienced a deflation scare, Fed Chairman Ben Bernanke wrote several pieces explaining how the U.S. could resort to very unorthodox policy actions to prevent a deflation and a liquidity trap like the one experienced by Japan in the 1990s. Those writings may, very soon, have to be carefully read and studied again.
Finally, while in the short run a global recession will be associated with deflationary forces, some ask whether we should worry about rising inflation in the middle run? This argument--that the financial crisis will eventually lead to inflation--is based on the view that governments will be tempted to monetize the fiscal costs of bailing out the financial system, and that this sharp growth in the monetary base will eventually cause high inflation.
In a variant of the same argument, some posit that--as the U.S. and other economies face debt deflation--it would make sense to reduce the debt burden of borrowers (households and, now, governments taking on their balance sheets the losses of the private sector) by wiping out the real value of such nominal debt with inflation.
So should we worry that this financial crisis and its fiscal costs will eventually lead to higher inflation? The answer to this complex question: likely not.
First, the massive injection of liquidity in the financial system--literally trillions of dollars in the last few months--is not inflationary, as it accommodates the demand for liquidity that the current financial crisis and investors' panic have triggered. Thus, once the panic recedes and this excess demand for liquidity shrinks, central banks can and will mop up all this excess liquidity.
Second, the fiscal costs of bailing out financial institutions would eventually lead to inflation if the increased budget deficits associated with this bailout were to be monetized, as opposed to financed with a larger stock of public debt. As long as such deficits are financed with debt--rather than by the printing presses--such fiscal costs will not be inflationary, as taxes will have to be increased over the next few decades and/or government spending reduced to service this large increase in the stock of public debt.
Third, to the question raised earlier: Wouldn't central banks be tempted to monetize these fiscal costs--rather than allow a mushrooming of public debt--and thus wipe out with inflation these fiscal costs of bailing out lenders/investors and borrowers? Not likely in my view. Even a relatively dovish Bernanke Fed cannot afford to let the inflation-expectations genie out of the bottle via a monetization of the fiscal bailout costs. It cannot afford to do that because a rise in inflation expectations will eventually force a nasty and severely recessionary Volcker-style monetary-policy tightening to get the genie back into its bottle.
Fourth, inflation can reduce the real value of debts as long as it is unexpected, and as long as debt is in the form of long-term nominal fixed-rate liabilities. An attempt to increase inflation would not be unexpected: Investors would write debt contracts to hedge against such a risk if monetization of the fiscal deficits does occur.
Also, in the U.S. economy, a lot of debts--of the government, of the banks, of the households--are not long-term nominal fixed-rate liabilities. They are, rather, shorter-term variable-rate debts. Thus, a rise in inflation in an attempt to wipe out debt liabilities would lead to a rapid repricing of such shorter term, variable-rate debt. And thus expected inflation would not succeed in reducing the part of the debts that are now of the long-term nominal fixed-rate form--i.e., you can fool all of the people some of the time (unexpected inflation) and some of the people all of the time (those with long-term nominal fixed-rate claims), but you cannot fool all of the people all of the time.
In conclusion, a sharp slack in goods, labor and commodity markets will lead to global deflationary trends over the next year. And the fiscal costs of bailing out borrowers and/or lenders/investors will not be inflationary, as central banks will not be willing to incur the costs of very high inflation as a way to reduce the real value of the debt burdens of governments and distressed borrowers. The costs of rising expected inflation will be much higher than the benefits of using the inflation tax to pay for the fiscal costs of cleaning up the mess that this most severe financial crisis has created.
Comments