Thursday, October 15, 2009

The deflation dog that didn't bark (3)

After the collapse in commodity prices late last year led to a sharp decline in headline measures of inflation (e.g., the CPI index fell 3.2% in the fourth quarter of last year), one of the more significant things to happen on the inflation front this year is the failure of deflation to appear. I've commented on this several times in the past. This is quite important because the prevailing/most popular theory of inflation is an offshoot of the Phillips Curve theory of inflation. This theory says that inflation declines when the economy weakens—when the economy is operating at a level that is below its potential, which means there are a lot of idle resources in the economy. Since the economy has been operating at a level significantly below its full potential (perhaps 7% below) for the entire year, the Phillips Curve theory of inflation would have predicted the emergence of at least some degree of deflation by now. But that hasn't happened, and that is the dog that didn't bark.

The Fed has been mightily concerned about the deflation threat all year for just this very reason. That is why they have been so easy, and plan to remain very accommodative for quite some time, since it will likely take many months or even years before the economy fully recovers.

Monetarists and supply-siders, on the other hand, prefer to see inflation as a monetary phenomenon. Supply-siders in particular like to watch market-based indicators of how easy or how tight monetary policy is, and to use these as a guide to what inflation is likely to do. For most of this year, these indicators have been suggesting that inflation pressures are rising, not falling: the dollar has been very weak of late, commodity prices have been rising almost across the board, the yield curve is very steep, gold has risen to a new all-time high above $1000/oz., and interest rates are very low relative to measured inflation.


For the first nine months of this year, the CPI has risen at a 2.7% annualized rate, which is slightly higher than its average over the past 5 and 10 years. The core CPI (ex food and energy) is up at a 2.0% rate over this same period. Neither index shows any signs of significant slowing. The deflation threat the Fed has feared has so far failed to materialize, and inflation instead has continued its trend of recent years. Since monetary policy typically acts with significant lags, the easy money of this year is likely to translate into a quickening in the pace of inflation next year.

12 comments:

Jay Norman said...

Scott:
As inflation slowly picks up, is the makeup of EMD and PAI reason to stay with them.

As always, thank you,

Jay

alstry said...

Scott,

What happens if we start to get rising debt defaults....do you think that might be a concern for deflation going forward?

It seems like Citi, Cap One, and Foreclosures don't show any signs of defaults slowing anytime soon....

That said, as you show, the data on the margins still looking up up up.

Scott Grannis said...

Jay: I think rising inflation is a good reason to have exposure to just about any kind of debt, but especially to high-yield debt. Anyone who borrows at a fixed rate of interest benefits from higher inflation because the dollars needed to repay debt become cheaper and easier to acquire as inflation rises. High-yield borrowers are likely to benefit disproportionately from inflationary policies because they are the ones most exposed to any slowing in cash flows or decline in selling prices. Also, spreads on high yield debt have the potential to decline much more than spreads on high quality debt, thus offering greater capital gains appreciation potential. EMD has a higher yield and lower average quality than PAI, so it is likely to do better in a rising inflation environment. Also, emerging market economies in general should benefit more than industrialized economies since they benefit more from the rising commodity prices and weaker dollar that come hand in hand with rising inflation.

AusGarry said...

Scott
Would you include Australia alongside the emerging markets - certainly would benefit from stronger commodities. Given its fiscal position its equityies would seem reasonable bets.

G

Scott Grannis said...

AusGarry: Australia is really a lot more advanced than emerging market economies, but it is a commodity-dominated economy. So Australia is in good shape here with a global reflation backdrop. There's another nice thing about Australia, and that is its monetary policy. Bravo for the RBA, the first major central bank to raise interest rates! I think the Aussie dollar has a good chance of remaining strong for a long time, and that alone is reason to buy Aussie equities.

Scott Grannis said...

alstry: I suspect that you will finally turn bullish on things after the stock market has gone up another 30%. Meanwhile, you're fighting the last war.

brodero said...

Wouldn't copper be a better metal
for inflation expectations? Gold
has not had a great record at predicting inflation over time.

Public Library said...

Oil back to 77 bucks. Your 30% forecast in equities will look shakier and shakier the higher that price goes.

America cannot absorb $140 oil this time around. The breaking point will be much lower.

Scott Grannis said...

brodero: Gold hasn't been a good predictor of inflation, but I don't know of any commodity that would be better. The one good thing about gold is that it is never "consumed." All the gold (about 130,000 tons) ever produced is still held by people. Annual production is only about 3% of the total supply of gold. So changes in production can have only a very limited impact on gold prices. The main driver of prices is demand.

With copper, changes in production and consumption can change the price easily. Yes, it can be stockpiled, but not nearly to the extent that gold is stockpiled.

One more detail: gold prices tend to lead commodity prices. I'll stick with gold as one of many indicators to watch for signs of inflation.

Scott Grannis said...

Public: I think oil starts to impose a threat on the economy at $100, give or take. I don't see the threat right now. Plus, money is easy; if the price level rises because of easy money, then the economy can withstand a higher oil price. Everything is relative. For now the message of higher oil prices is that demand is strong and economic activity is rebounding. Economic growth does not necessarily bring with it the seeds of its own destruction.

REW said...

Scott,
I ask you to expand on the rationale for owning debt as inflation picks up. The real beneficiaries are the debtor, who repays in less valuable dollars. So the corporations benefit. As a bond owner, or creditor, I get repaid in less valuable dollars. I understand that very risky debt might reward me, as the default risk declines, but I don't understand your claim that "rising inflation is a good reason to have exposure to just about any kind of debt". What about low risk, high quality corporates? In fact you are on the record as shorting treasuries (owning TBT). Please expand.
Thanks as always for your blog.

Scott Grannis said...

REW: I think I wasn't clear about why it is good to have debt exposure in a rising inflation environment. I should have emphasized that having exposure to risk-free debt such as Treasuries is a very bad idea, given that interest rates are so low and offer no protection against the loss of purchasing power that comes with higher inflation.

I meant to say that high-yield debt was a good thing to have, and that is because a) yields are still very high relative to inflation and thus they offer significant protection against inflation, and b) the risk of default (which is a big part of the reason that yields are so high) should decline materially in a rising inflation environment, thus increasing the expected return on HY debt.

The average yield on HY debt is about 10% according to my Bloomberg. If default risk drops significantly because easy money helps get the economy out of its funk and makes it easier for debtors to receive better cash flow, then the realized yield will be substantially higher than current inflation, and probably higher than what inflation is likely to average even in a rising inflation environment. Equities might do better, of course, but you never know.