U.S. Deflation Risk

Slower economic growth, undesirably high unemployment combined with softer inflation through the second quarter have increased concerns over the potential for a U.S. deflationary cycle accompanied by declining demand and wages.

August 24, 2010:  Over the past 12-months (July yoy), the U.S. consumer price index rose 1.2% compared to a 1.1% yoy gain in June and a 2.7% annual rate last December.  The yearly CPI has averaged 2.7% over the past 20 years.  Year-over-year increases in the U.S. producer price index and import prices (through July) were up a respective 4.2% and 4.9%, noticeably above their 20-year average of 2.2% and 1.8%.

Given these yearly price measures, why are we seeing so much concern about deflation?  Mainly because the degree of fiscal and monetary stimulus that has been provided to the U.S. economy over the past 3-years has not adequately been able to stimulate the economy.  Extraordinarily easy monetary policy combined with attempts at fiscal stimulus have not produced meaningful job creation.  It's been nearly 2 years since the Federal Open Market Committee lowered its target funds rate to near zero percent (Dec '08).  Furthermore, many of the symptoms of a weak economic climate continue, namely; a) excess production capacity, b) excess labor capacity and c) broad uncertainty that has led to constrained lending, borrowing and spending.  With U.S. real GDP having decelerated from 5.0% in Q4 '09, to 3.7% in Q1 '10 and 2.4% in Q2 (all annual pace figures) combined with the latest deterioration in home sales and rising jobless claims, worries over slower growth in the quarters ahead have heightened concerns over the potential for deflation.

The August 10 FOMC statement noted "measures of underlying inflation have trended lower in recent quarters and, with substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to be subdued for some time."

Concerns over falling prices have given many investors the confidence to buy U.S. government and high-quality municipal and corporate debt despite some of the lowest nominal yields seen in over 50 years.  Furthermore, the continued decline in Treasury yields, seen since April amid the continuation of record budget deficits, signals that investors are increasingly desperate to find "safe" and dependable investment income.

Falling Treasury yields and a fed funds target range stuck at 0% to 0.25% are likely reinforcing a climate of weak economic expectations which contribute to the deflationary psychology.  

Disinflation:  The latest annual headline and core U.S. CPI figures, through July, are running at 1.2% and 0.9%, below the Federal Reserve's informal target of 1.5% to 2.0%.  This is mostly reflecting disinflation, a noticeable slowing down of price increases.  At this juncture, after a few months of uninterrupted declines in the U.S. CPI and PPI (between April and June), it might still be premature to conclude that deflation - defined as a drop in general price levels - has become a secular trend for the U.S. price structure.  

On August 13, the Bureau of Labor Statistics reported that the cost of living in the U.S. increased 0.3% in July - it was the first monthly increase in the headline U.S. consumer price index since March and the largest increase of any month seen since August 2009.  Although the monthly increase in the CPI did little to shift the market's concern over the potential for a run-in with deflation, the end of 3 straight months of headline CPI declines (seen during Q2) added some questions as whether some positive price traction can be reestablished in the near-term.  Given the economic slowing visible so far in August, it seems unlikely that there was much upward price pressure this month - the August CPI outcome will be released on September 17.

In the event the balance of the year continues to reflect risk aversion, continued weakness in job growth, excess capacity and/or a deceleration in consumption, it would certainly raise the likelihood of outright price deflation.  The latest Bloomberg consensus forecast from August 11th anticipates a 1.1% annual U.S. headline CPI rate in Q3 followed by 1.0% in Q4  and 1.0% in Q1 '11, certainly below the Fed's desired range but not firmly in the deflation category.  The August 11th consensus expectations for the annual U.S. core CPI (ex-food & energy) were 1.3% (Q3), 1.1% (Q4) and 1.2% (Q1 '11).

"Real" yields reflect deflation worries and risk aversion:  The yield on 5, 10 and 30-year U.S. Treasurys exceeds the annual headline consumer price index currently while Treasury yields with maturities out to February 2015 are below the latest annual CPI (1.2% in July).  The negative gap between the inflation rate and the Treasury yield indicates investors are currently willing to earn less than the inflation rate for the next 4.5 years.  There are 3 key reasons investors are willing to accept a negative "real" (inflation adjusted) yield; 1) investors anticipate that the annual inflation rate will decline further over the term of the investment, 2) investors anticipate price appreciation (yields to fall) and expect to sell the instrument for a profit, and 3) risk averse investors are concerned about preserving their capital and want to hold Treasury securities despite the negative "real" (inflation adjusted) yield.  

As can be seen in the following chart, "real" yields were even lower at the end of 2009 due to an annual inflation rate that exceeded the most recent CPI by 1.5%.  For some investors, the current "low" nominal Treasury yield environment looks attractive on a "real" CPI adjusted basis relative to the end of last year. 

Fed policy:  The Federal Reserve's highly accommodative monetary policy is a pro-growth policy that is also intended to defend the low side of the Fed's informal inflation target of 1.5%.  The Fed's latest plan (August 10th) to invest the cash flow proceeds from its Agency and MBS holdings into longer-term Treasury debt is intended to help support the recovery -  it will keep constant the Fed's holdings of securities at their current level.  The action is not only an attempt to further lower longer-term Treasury yields but it is also intended to increase the chances for more inflation and somewhat higher inflationary expectations.  

Long-term U.S. inflation expectations have been gradually slowing since late April.  As can be seen from the following chart, the gap between 10-year U.S. Treasury yields and 10-year inflation protected securities (one measure of long-term U.S. inflation expectations) currently reflects investors anticipating U.S. inflation will average about 1.5% over the next 10-years.

What are some of the considerations that would add to the risk of U.S. deflation at this point?

• Productivity gains - particularly if those gains were to outpace demand.  This concern may have been partially negated for the time being.  The Bureau of Labor Statistics reported on August 10th that U.S. nonfarm productivity fell 0.9% in Q2 as employers expanded the workweek by the most in 4 years.  Q2's decline in productivity was the first quarterly drop since 2008. 
• Recession - a contracting economy increases the risk of deflation because inventories tend to rise as sales slow and many goods need to be liquidated to pay down debt leading to price cuts and distressed sales.  Despite the cautious market tone and the fragile economic climate, the U.S. economy continues to show modest levels of growth, however, the latest data on employment and housing have been very weak.  The latest U.S. real GDP figures from the Bureau of Economic Analysis showed a 2.4% annual rate of growth during Q2.  On a year-over year basis, real GDP was up 3.2% in Q2 - these figures are expected to be revised lower on August 27th.
• Poor income growth - unless income grows faster than the rate of inflation, it is unlikely the economy can grow much faster than inflation unless debt expansion sustains economic growth.  Without debt expansion and/or income growth, it will be difficult for personal consumption to grow.  The latest figures from the Bureau of Economic Analysis show that through June, yoy U.S. personal income was up 2.6% (modestly above the annual inflation rate).  Rising unemployment increases the risk of deflationary pressures because workers are more willing to accept falling wages to remain employed. 
• A negative economic shock - an unwelcome global surprise would no doubt be a major setback for growth and confidence adding to overall consumer and business uncertainty leading to general economic retrenchment.  The longer the duration of such retrenchment, the greater the potential for deflation.
• Falling commodity prices - slower global growth or fears of a recession in a major economy (like the U.S.) would tend to reduce demand for commodities at the earliest stages of production first.  The price performance of energy products, industrial metals, grains, livestock and even precious metals can provide some perspective on the shifting momentum of global deflation risks even though supply considerations, such as weather, can impact pricing dynamics meaningfully in the near-term.  Currently, the broad based-CRB commodity index is down 7.4% year-to-date - this degree of decline is discouraging but not yet an indication that prices are collapsing or that the risk of serious deflation is imminent.  So far this year, copper prices are about flat, nickel is up 14% while Aluminum is down nearly 10%.   
• Falling money supply - If the U.S. money supply stopped growing, the risk of price deflation would be greater.  According to the Federal Reserve, as of August 9, the U.S. M1 money supply aggregate is up 4.7% (annual change) while the broader M2 money supply measure is up a very modest 1.9% (annual change).   
• Further deleveraging - Declines in private sector consumer credit growth have a tendency to limit personal consumption demand.  According to the Federal Reserve's flow of funds report through Q1 2010, total household debt (includes residential mortgage and consumer credit) fell to $13.54 tn in Q1 for a 7th straight quarterly decline.  This measure of the U.S. consumer's indebtedness peaked at $13.92 tn in Q2 2008.

The following considerations would lessen the likelihood of deflation:

• Sustained economic recovery - would lessen the tendency for double-dip expectations. 
• Job growth - would likely lead to higher wages and stronger consumption and spending.
• Weaker U.S. dollar - would likely add to U.S. import price pressures and benefit net U.S. exports, a key GDP component.  
• Higher commodity prices - upward global commodity price pressure, even in the context of soft U.S. demand, would tend to increase input costs having some impact on inflation expectations.
• Increased money supply - a sustained increase in the money supply (monetary inflation) usually results in price inflation.
• More private sector borrowing - more leverage typically leads to more spending, investment, hiring and overall business activity.
• Higher capacity use - in the event the U.S. uses more of its productive capacity, there's less risk of deflation materializing, although global production capacity continues to grow rapidly which adds uncertainty to U.S. production outcomes.  The U.S. capacity utilization rate was 74.8% in July, the highest use rate since Oct 2008.  Although current utilization is well below the 80% seen on average over the past 20 years, excess production slack is gradually being eliminated.

Summary:  With fears of deflation increasing amid the latest softening in U.S. economic data, we are likely to see increased debate surrounding what the the Federal Reserve might engineer to inflate and stimulate the economy.  With the Fed's target rate effectively at zero percent already, policy efforts to head off near-term deflation risks will likely involve restarting quantitative easing, a practice that will enlarge the Fed's balance sheet and add wider dimensions to an eventual exit strategy.  

The declines in Treasury yields, since May, have already priced in a mild double-dip recession outcome leaving yields vulnerable to rise in the event a double-dip recession is avoided - expectations for the economy's performance have been broadly scaled back in recent weeks.

In the Fed's debate on confronting potential deflation risks, the central bank must ultimately base its actions on its own forecasts.   Given that great attention was given to how the Fed would exit from its extraordinary accommodation just 4 months ago, due to concerns over the potential inflation consequences of previous Fed actions, the rapid shift in policy priorities suggests the current fears of deflation may prove fleeting.  

To gauge the emerging deflation risks real-time, it's probably most helpful, over the next few weeks anyway, to look at commodity price performance given that riskier asset class prices have deteriorated in recent weeks.  In the event a price plunge in the broad-CRB index were to develop, on top of all the other concerns that have made deflation fears so prominent recently, the likelihood of a negative annual CPI would increase.  For now, however, near-term deflation risks are certainly there, but the price impact seems contained.  The broad-based CRB index is up 0.5% yoy.  As mentioned above, the index has declined 7.4% so far this year - after climbing 7.7% in just the months of June and July.    

Robert Podorefsky, Interest Rate Strategist (617) 973 - 4091