Inflation vs. Deflation

Traders, economists, strategists, central bankers are all exposed to a new dilemma: is the US economy experiencing an inflationary or a deflationary pressure? On one side, under a global turmoil environment where most economies are shrinking considerably, prices tend to fall and subsequently the aggregate demand for goods and services subsides. On the other side, due to unprecedented central banks’ expansionary money supply policies many analysts expect a rapid increase in the level of prices. The solution to the problem still represents a challenge for many investors since the near-term investment strategy is very much correlated with the tendency of the price index.
Should the US economy continue to struggle in the near future then the consumer price index (CPI) will turn into negative territory. In a downward business cycle when the aggregate demand weakens, corporations generally reduce prices just to remain in business. Since the beginning of the year, the CPI has hovered near the flat line. Due to the central banks massive quantitative easing programs the money supply has expended tremendously. Flowing from the central banks to consumers and businesses via the financial intermediaries, more money becomes available for spending. However, the American consumer has slashed its borrowing by a record $21.6 billion. Consumer credit fell by 10 percent in July to an annual rate of $2.5 trillion, marking the sixth consecutive month of decline. The expected unemployment rate of 10 percent corroborated with a massive decline in household wealth will bring uncertainty about the future growth in spending by households. The general consensus shows that consumer spending will remain tamed for the rest of the year and 2010. Despite cash-for-clunkers program and Fed’s near-zero interest rates, non-revolving debt (e.g., car loans) plunged by $15.4 billion in July and revolving credit (e.g., credit card loan) fell by $6.1 billion. According to FBR Capital Markets, revolving credit may shrink by another 20 percent by Dec ’09 as consumers turn to debit cards to pay their bills. Since July 2007 the Americans lost approximately $13.9 trillion in household wealth, due to the house value depreciation and the stock market decline. On top of that, the US economy has lost 6.9 million jobs since December 2007. Consequently, the labor cost, one of the most critical CPI components, did not exhibit any inflationary pressure.
According to the modern macroeconomics theory, there is a lagging period before the effects of a major change in the monetary trend start to become apparent in the prices of commodities and everyday goods and services. During this period evidence will often point to deflation, even though the inflation threat is rising. These days, the notable exceptions are the price of gold and the price of oil which are likely to commence a major upward trend in the early part of a new inflation cycle. The reason is that these prices are not the sole result of the demand-supply equilibrium. Both markets are mainly dominated by large speculators who take positions in anticipation of the rise in the inflation rate. In sum, even though the inflation threat has begun to increase the deflationists will probably look right for at least another year. The main point of contention revolves around the ability of the monetary authorities (Federal Reserve and Treasury Department) to keep the total supply of money in check. Since the beginning of the financial crisis, Treasury-Fed team has demonstrated the power to promulgate monetary inflation under almost any economic circumstances. If the central bank has the luxury of reversing the monetary policy by raising the benchmark interest rates, it becomes more difficult to set a ceiling on the quantitative easing programs. The bond market will eventually impose a practical limitation on the government’s ability to inflate because increasing the money supply becomes counter-productive once the bond market begins to anticipate rapid currency depreciation. Nevertheless, if price-related evidence continues to favor the deflation view over the coming year then this limitation will not arise anytime soon.
As the theory teaches us, the Treasury yield curve can follow various changes of its slope over time. When the yield curve is sloping upward, the temptation is to borrow short and lend long. As a result the curve will flatten. Judging by the bond markets, one very likely scenario might be such that the investors could favor short-maturity debt for the next three to five years as long as markets expect yields on short maturities to be anchored near current low levels. It is well-known that shorter-term bond yields tend to track central bank interest rates while longer maturities are more influenced by inflation.
One of my favorite barometers of CPI is the implied inflation expectation rate using the Treasury Inflation-Protected Security (TIPS). Issued by the US Treasury to protect investors against inflation, the Treasury adjusts the principal value of the TIPS using the CPI, published by the Bureau of Labor Statistics. Estimates of intermediate-term inflation expectations could be approximated with the yield difference between the 5-year Treasury bond and the 5-year TIPS. If we do this exercise using the Bloomberg terminal, we can notice that this measure of inflation expectations is hovering around 1 percent. Estimates of longer-term inflation expectations can be derived using the forward nominal yields and the forward real bond yields. For instance, if we are interested in inflation expectations for the period from 2014-2019, we compare the forward nominal yield (5×10 UST) to the forward TIPS yield (5×10 TIPS) and we imply the forward breakeven inflation rate. In conclusion, we can very well expect deflation in the short term and inflation in the long term.

Advertisement