Friday, May 16, 2014

Forget about deflation risk

Producer price inflation in April was quite a bit higher than expected (+0.6% vs. +0.2%), and core (ex-food and energy) prices jumped 0.5%. April consumer price inflation, on the other hand, was about as expected. However, both the total and core versions of the PPI and the CPI now say that inflation in the past year has been at least 2%, whereas they were registering levels of less than 1% about six months ago, as shown in the following charts.

Could this be the beginning of a significant increase in inflation? Perhaps, but it's still premature to make that call, even though I've been worrying about rising inflation for the past five years. What it does say, however, is that deflation is a no-show. This is not the stuff of which deflations are made.

Fed monetary policy for years has been geared to fight the threat of deflation, and policy is still dominated by the fear of inflation being too low. Adding to the Fed's concerns were the still-sluggish rate of economic growth and the unprecedented "output gap" (i.e., idle capacity, which I estimate could be at least 10%) that is still growing despite 5 years of unprecedented monetary and fiscal stimulus. Conventional economic thinking would have thought this impossible, and conventional thinking today worries that the weak economy will surely exacerbate the threat of deflation, because we supposedly have too many goods and services (i.e., too much supply) chasing too few dollars (i.e., not enough demand).

Yet now we have inflation at 2% or more, at the top of the Fed's preferred 1-2% range, at a time when the Fed still has its metaphorical pedal to the metal. I have argued for years that the Fed hasn't really been printing money, so I don't think this metaphor is apt, but I've also noted that the justification for the Fed's massive bond purchases (the world's extraordinary demand for money and money equivalents) likely won't last forever. The recent pickup in inflation is one more sign that the demand for money may be easing, and if so, then the Fed's extraordinary supply of money may create an oversupply of money. If inflation starts to register 3% or more, (I'll take a bit of deflation any day rather than inflation of more than 2% a year) then that will have huge implications for monetary policy. The Fed is going to have to accelerate its tapering and shift into tightening mode, and interest rates are going to move higher across the board, by much more than the market currently expects. I'm not sounding the alarm yet, but it's a risk that can't be ignored, no matter how weak the economy's growth rate.

Weak economic growth does not inoculate an economy against inflation. On the contrary, inflation often thrives when growth is weak, and too much inflation can seriously debilitate an economy. I should know, since I lived in Argentina for four years in the late 1970s, during which time economic growth was abysmal and inflation lived in triple-digit territory. If the Fed responds to the threat of higher inflation in a timely and adequate fashion, there is no reason that should hurt the economy.

This business cycle has been a boon to economists, because it has destroyed the progressive myths that government spending and easy money can stimulate an economy. It has also destroyed the Phillips Curve theory that says that persistently high unemployment leads to low or negative inflation.

So now we await the dawning of a new era of public policy, one which I hope will be dominated by the belief that monetary policy and fiscal policy need to focus on delivering conditions that are optimal for the private sector to thrive: low marginal taxes, low and stable inflation, and low regulatory burdens. Washington needs to reduce marginal tax rates on businesses and individuals, while also eliminating deductions and subsidies. This shouldn't be too difficult, given the dramatic progress to date in reducing the budget deficit. Reducing regulatory burdens is also critical, since they impose a deadweight loss on the economy. It should soon become obvious to everyone that Obamacare is only making things worse, and that only by introducing market-based reforms can we improve healthcare.

Deflation is not a threat; Big Government is.


William McKibbin said...

Got it -- let's forget about deflation risk -- while we are at it, let's forget about the risk of stagnation in real working wages, real home values, and the employment to population ratio that could last decades if not the rest of the century -- yes, let's forget about all of those bad things forever -- 'poof'...

Matthew Grech said...

Scott, I'm in agreement with you, completely, re: deflation. But just what the heck is the 10-year Treasury yield telling us? I'm asking sincerely, not trying to be snide.

Joseph Constable said...

Total Credit Market Debt Outstanding (FRED TCMDO) is $59 trillion, and MZM is $13 trillion. Where did the $46 trillion go? All overseas? Can it come back and cause inflation that the Fed cannot control?

Scott Grannis said...

The 10-yr yield is telling us that higher inflation is still just a speculation; that the market does not think the economy has the potential to do better than 2-3% growth; and that inflation is likely to remain low. In other words, we will see a continuation of what we have experienced in the past several years.

The yield curve also tells us that the market expects the Fed to begin raising short-term rates in a year or so, but slowly.

Scott Grannis said...

Total credit outstanding is always many multiples of the money stock. Most of the credit outstanding is created by private parties (A loans to B) and does not translate into a larger supply of money. Only banks can create new money. With the exception of the federal government, debt levels are not unusually high or threatening. The private sector of the economy has deleveraged to a significant extent in the past five years.

Matthew Grech said...

Scott: Again, I agree with your conclusions re: the 10-yr yield (inflation still just speculation, mkt doesn't see better than modest growth, perpetuation of what we've seen the last few years). But I wonder if there isn't something more at work... And I wonder about this in the context of the fact that the yield has recently gone from 3% to 2.5%, a spectacular move when you think about it, since all the elements you mentioned were firmly in place when the yield was 3%. The recent decline in yields has also taken place absent of the other things we'd expect to happen amid such a decline. For example, high yield spreads haven't widened. This is incredible. On a day when the WSJ had as its lead article "World Worries about Global Growth" you'd expect junk spreads to widen. Also, broadly, commodities have been moving higher amid the 10 year yield decline. Many other things don't line up with the historical messaging of this decline in a major yield indicator.

I strongly wonder if something else isn't at play here (and even more than a massive unwind of the short Treasuries trade that Wall Street entered the year). Could it be that we're actually seeing a shortage of Treasuries in the world. So many entities (pensions, municipalities, corporations, others) have a mandate to own safe securities that we have an overload of price-insensitive buyers. Debt issuance has not been high either. This is the only explanation I can come up with that is consistent with the other indicators (or lack thereof). As wacky as this would be (relative to history) wouldn't this also be consistent with an environment in which money velocity has been super-duper low?

Scott Grannis said...

10-yr yields have been moving between 2.5 and 3% for the past year. The ups seem driven by hopes of stronger growth, and the downs by disappointments. Not much going on as I see it. Breakeven spreads on TIPS have also been moving in a fairly flat range. Credit spreads are low and relatively stable because while the market doesn't see stronger growth it doesn't see a recession either. Financial conditions are generally very healthy even though growth is modest.

I'm not a believer in the "shortage of Treasuries" theory of generally low interest rates. I would rather characterize it by saying that there is a general lack of enthusiasm and risk aversion is still predominant. And there are lots of reasons for those sentiments to exist.

William said...

This is a global bond market rally. In recent weeks Russia sold 20% of its US Treasury holdings I read, apparently to support the Ruble. On the other hand there could be countries and citizens in Eastern Europe purchasing more US Treasuries and perhaps some small Asian countries as well.

William said...

ECRI Weekly Leading Indicator Reaches New High

The WLI rose to 136.2 from the previous week's 135.8. The growth rate rose to 4.5%.

Meanwhile, U.S. inflationary pressures were higher in April, as the U.S. future inflation gauge climbed to 104.7 from the revised March 103.9 reading, according to data released Friday morning by the Economic Cycle Research Institute.

William said...

AAII Investor Sentiment Survey

up 4.8
up 1.3
down 6.1

Long-Term Average:

The Roller said...

William, these latest AAII sentiment figures suggest 66.90% of investors are not buying stocks.


Benjamin Cohen said...

The Fed measures inflation using the PCE deflator, now at about 1 percent core. The CPI probably overstates inflation, although one can debate the merits of any inflation indicator into the wee hours of the morning.

We are seeing, in fact, deflation in unit labor costs since 2008. Maybe we will not see a general deflation, but the idea that inflation will rage out of control is probably even more remote.

I can't say I agree that 3 percent inflation would be TEOTWAWKI. The Fed's target PCE average is 2 percent, and we have been at 1 percent for a long time, meaning we would need 3 percent on the PCE deflator for a while to get back to average.

But no worries---the FOMC is not in the mood for any rate of inflation above 1.5 percent on the PCE. I suspect this is monetary asphyxiation.

Frankly, I would love some boom times and 3 percent to 4 percent inflation. Bring it on. Set the house on fire.

The 1960s has terrific real growth, and inflation in low single digits. Not so bad.

Scott Grannis said...

The core PCE deflator for April will most likely register 1.9% annualized inflation over the past three months, 1.6% over the past six months, and 1.5% over the past year. Inflation by all measures has definitely picked up of late, even though the economy has slowed. This is the unusual thing because it is quite contrary to most expectations.

Benjamin Cohen said...

BTW, I would not be so casual about deflation, especially if it gets into property. Banks lend on real estate and it is most people's biggest investment.
As Japan found out, sustained deflation in property is an economy killer.

William McKibbin said...
This comment has been removed by the author.
theyenguy said...

On Monday, May 19, 2014, Global Dividend Growth Excluding The US, DNL, a Large Cap Blend ETF, likely peaked out, as Industrial Growth Stocks, FXR, PSCI, RZG, SOXX, XTN, MHK, traded higher on the day, and as Emerging Market High Dividends, EMHD, and Emerging Market Financials, EMFN, traded to new rally highs, on higher Emerging Market Currencies, CEW.

The seigniorage, that is the moneyness of the Banker Regime, started to give way today, as traders derisked from debt trades and delveraged out of currency carry trades in Australian Equity, AUSE, KROO, EWA, WBK, BHP, on the trade higher in the Yen, FXY, and a trade lower in the Australian Dollar, FXA. And likewise they took flight from the Middle East Equity, GULF, MES. All as Zero Hedge posts Conflict Between China And Vietnam Is Imminent - China Piles Troops, Tanks, Artillery And APCs Near Vietnam Border.

German Small Caps, GERJ, traded lower as Deutsche Bank, DB, traded lower.

Brazil, EWZ, EWZS, traded lower as Brazil Banks, BBD, BSBR, traded lower, as Spain’s Bank, SAN, traded lower.

High Yield Interest Rate Hedge, HYHG, Brazil Electric Utilities, EBR, CPL, ELP, PAM, DEP, and US Electric Utilities, XLU, PUI, traded lower as the bond vigilantes called the Interest Rate on the US Ten Year Note, ^TNX, higher to 2.54%, and steepened the 10 30 US Sovereign Debt Yield Curve, $TNX:$TYX, which is seen in the Steepner ETF, STPP, steepening.

Junk Bonds, JNK, and Ultra Junk Bonds, UJB, traded to new all time highs, while Aggregate Credit AGG, traded lower, on lower 30 Year US Treasury Bonds, EDV, and lower US Treasury Notes, TLT.

The bond vigilantes took control of the Benchmark Interest Rate, ^TNX, when it traded higher from 2.49%, on October 23, 3013. And today May 19, 2014, they reasserted their control over this Benchmark Interest Rate, by calling it higher yet to 2.54%, reflecting that the Rider on the White Horse, seen in Revelation 6:1-2, has the Bow of Economic Sovereignty, and is effecting economic coups throughout the world, as is seen in the political instability in SE Asia, and as is seen in the Ambrose Evans Pritchard report Putin To Give Ground In China To Seal Gass Deal. The long coveted prize would allow Russia to switch sales from Europe to the Far East and transform the Eurasian gas market. Higher interest rates globally mean economic destabilization and economic deflation, coming largely from investors derisking out of debt trades and deleveraging out of currency carry trades.

Economic growth was a largely a side benefit, that came from investment gains, flowing from the credit stimulus of Global ZIRP; economic growth was a function of the bygone era of currencies, and the age of credit.

The dynamos of creditism, corporatism, and globalism are winding down on the failure of credit and breakdown of currencies. The singular dynamo of regionalism will be powering up the age of debt servitude, where regional economic stability, security and stability become the driving factors of economic activity.

Out of soon coming chaos, in particular a global credit bust and financial system breakdown, known as Financial Armageddon, seen in Revelation 13:3-4, a new era of trust will emerge, that is one where residents of the world’s ten regions come to embrace and in fact give homage to policies of diktat of regional fascits governance, and comply with schemes of totalitarian collectivism in mankind’s seven institutions, as is held forth in the dream given by angels to the Apostle John, while he was in his 90s living on the Isle of Patmos, and presented as Bible scripture in Revelation 13:1-4.

Hans said...

Mr Grannis, your best threat of the year! Your last paragraph sums up the real picture in America.

Ben Jamin, you have clearly been in the forefront in denouncing the utter and clear failure of the VA.

More proof of the utter failing of governmental agencies.

William said...

While Scot is enjoying a well deserved vacation, an interesting perspective on inflation today from Dr. Ed Yardini

"The IMF’s measure of the world CPI inflation rate recently peaked at 4.9% during September 2011 and fell to 2.8% during March. Inflation is subdued for advanced economies (1.3%) and relatively low for emerging ones (5.0%).

"We believe that the ultra-easy monetary policies of the major central banks might actually be keeping a lid on inflation. That’s not what we all learned in school, of course. We were taught that easy money stimulates demand, which boosts inflation, especially when economies are growing at full capacity.

"However, easy money can also boost capacity. That certainly might explain why the commodity “super cycle” lasted only 10 years (from 2001-2010) rather than 25-50 years, as was widely hyped. China’s borrowing binge financed lots of excess capacity, as evidenced by its PPI, which has been falling for the past 26 months.

The core CPI inflation rate for the 34 advanced economies in the OECD remains subdued below 2.0% y/y. However, it did rise during March to 1.7%, the highest since October 2012. The comparable inflation rate for the G7 was only 1.4% for the fifth consecutive month through March.

"Credit conditions are especially easy in the advanced economies. Rather than stimulating demand and consumer price inflation, easy money has boosted asset prices. It has also facilitated financial engineering, especially stock buybacks. Private equity investors are funding capacity expansion by seeding entrepreneurs who are developing productivity-enhancing innovations.

Benjamin Cohen said...


The above PCE deflator, minus food and energy, shows 1 percent inflation for last 12 months....

Not sure where you get your series...are we looking at same thing?

Kos said...

Scott I truly wish you had "search" on your site as I was trying to locate a few of your older posts on TIPS and inflation. Great job however addressing deflation and the Fed's impact. Keep it up :)

Scott Grannis said...

Kos: There is a search field in the upper left hand corner of your browser, and it works quite well.