Tuesday, April 15, 2014

Deflation risk is low and that's good for the dollar

There seems to be an inordinate amount of concern these days about the threat of deflation. Yes, inflation is low, but there's nothing wrong with that. Inflation in the U.S. is currently running around 1.5 - 2.0%, which is as low as it's been on a sustained basis since the early 1960s, but that was a time of robust economic growth.

Many commentators use a "black hole" or a "slippery slope" analogy when talking about the risk of deflation. They argue that just a little bit of deflation can lead to more; that deflation can be very difficult to escape; and that once deflation sets in it is unambiguously bad for economic growth. Analogies like these can become popular and convincing to the layman, but that doesn't mean they are good or valid. I've debunked the "stall speed" analogy—which says that when an economy is growing very slowly it is vulnerable to collapse—in several previous posts, but it remains popular to this day and contributes, unjustly, to many investors' concerns about investing in risk assets.

Deflation doesn't work like a black hole or a slippery slope. Deflation is what happens when an economy experiences a shortage of money relative to the demand for money. When money becomes scarce, prices of things tend to fall because the value of money increases. A scarcity of money can result from monetary policy that is very tight (e.g., when a central bank pushes short-term interest rates significantly above the rate of inflation) or when the demand for money is very strong and a central bank fails to accommodate this extra demand with extra money and/or lower real interest rates. As I'll show in the charts below, there is no evidence of a scarcity of money in the U.S. today.

The chart above shows the inverted value of the dollar and a broad index of non-petroleum commodity prices. This shows there was a scarcity of dollars in the early 2000s because the dollar was strong and commodity prices were weak. When the Fed subsequently relaxed monetary policy, the dollar weakened and commodity prices rose. The sharp rise in the dollar and the sharp decline in commodity prices in 2008 are evidence that the Fed was slow to react to a big increase in the demand for money that caused a relative scarcity of dollars. Dollars were so scarce in late 2008 that the bond market came to expect years of deflation. Commodity prices currently show no sign of weakness and are in fact quite high from an historical perspective, just as the dollar today remains quite weak—from which we can conclude that there is currently no scarcity of dollars that might cause deflation.

As the chart above shows, the dollar is indeed quite weak from an historical perspective, even when adjusted for inflation and compared to a broad basket of other currencies.

With the dollar weak and commodity prices generally strong, it is not surprising that gold prices are also quite strong. To be sure, gold prices have dropped meaningfully over the past few years, but they are still very strong relative to other commodity prices, as the chart above shows. As I see it, gold "overshot" commodity prices and is now correcting. I've been anticipating a further correction in gold prices for the past year. It's hard to worry about deflation when gold and commodity prices are still trading at levels far in excess of where they traded during the 1980-2000 period.

As the chart above shows, the bond market is convinced that the Fed is not putting the monetary screws to the economy. Every recession on this chart was preceded by a sharp increase in real short-term interest rates and a flattening or inversion of the yield curve, both of which are classic signs of monetary tightening. Today we have just the opposite: very negative short-term real rates, and a relatively steep yield curve. Monetary conditions are accommodative today, not tight. This implies that a recession is extremely unlikely, and it is strong evidence that money is not scarce—thus deflation risk is very low.

Today's release of the March CPI statistics shows that inflation is running quite solidly at just under 2% (see chart above). This is in line with inflation as measured by the broader PCE and GDP deflators. This is not scary or dangerously low, this is good. If inflation averaged 1.5% per year for the foreseeable future, I would expect the economy to strengthen since low and stable inflation would boost confidence, strengthen the dollar, and make the U.S. more attractive to investment.

Don Luskin, a good friend, superb analyst, and fellow supply-sider, inspired me with a chart similar to the one above in his current research report. What this shows is that changes in the growth rate of housing prices (I've used the Case Shiller 10-city index) tend to lead changes in the Owners' Equivalent Rent component of the CPI (OER accounts for about 25% of the CPI) by about 18 months. What this suggests is that the CPI is very likely to be boosted over the next year or so by the strong growth in housing prices that we have seen in the past year or two. We've already seen a little of this in recent months, and there's likely a lot more to come. Rising housing prices tend to lead to rising rents, and that's how housing prices feed into the BLS's calculation of inflation. It's hard to worry about deflation when housing prices are rising.

In contrast to the U.S., the Eurozone is somewhat vulnerable to deflation, because monetary conditions there are relatively tight. You might not think so if you just looked at Eurozone interest rates, since they are quite a bit lower than their U.S. counterparts. German 2-yr bunds yield 0.12% vs. 2-yr Treasuries at 0.4%, and 10-yr bunds yield 1.5% vs. 10-y Treasuries at 2.6%. Typically, monetary tightness shows up as rising interest rates, but this is one of those times when interest rates are very low because inflation is very low and economic growth is relatively weak and money is relatively scarce. Although the ECB has taken significant steps to reduce short-term interest rates, it has not engaged in the massive Quantitative Easing that the Fed has. Weak growth and very low inflation are fertile ground for strong money demand, and it's probably the case that the ECB has not been aggressive enough in its willingness to supply money, and that's why money is relatively scarce in the Eurozone.

As the chart above shows, core inflation in the Eurozone has been less than 1% over the past year, almost a full point lower than U.S. core inflation. The harmonized measure of CPI in the Eurozone is up only 0.5% in the past year, and it is up at a mere 0.35% annualized rate over the past six months. The inflation facts support the theory that money is tighter in the Eurozone than in the U.S..

It's also the case that the euro is a good deal stronger than the dollar. The chart above shows my calculation of the euro's Purchasing Power Parity vis a vis the dollar. At the current level of 1.38, I figure the euro is about 20% "overvalued" against the dollar. The Eurozone faces a moderate amount of deflation risk (if you can call it a risk, since there is no a priori reason an economy with falling prices can't grow) because the euro is relatively strong and inflation is very low. It's not a serious risk, because gold and commodity prices in euro terms are still very high and housing prices in the peripheral Eurozone markets are rising, but it's certainly more of a risk than in the U.S.

What all this means is that the Fed has more leeway than is commonly thought to tighten policy should that become necessary—because monetary policy is relatively easy—whereas the ECB may have to ease policy further because monetary policy is still relatively tight. If the Fed tightens sooner than expected and the ECB eases (e.g., by pursuing some form of QE), that would likely result in a meaningful rise in the dollar vis a vis the euro. And that would be a good thing for just about everyone.


Anonymous said...

Excellent piece Scott. I really enjoyed and learned from your explanation of demand for money, monetary policy, and deflation. Thanks as always.

Benjamin Cole said...

Per usual, excellent post.

The Fed, of course, targets not the CPI but the core PCE deflator, which is right around 1 percent now, a full percentage point below its stated target.

(Many say the CPI overstates inflation, and this is often stated in right-wing circles when they debunk the immolation of middle-class America).

Interesting that our central bank is below its inflation target but still plans to halt QE.

I still see a Japan-lite scenario for the USA, of very slow growth, and not much in equities markets. I am unsure about about property, as real estate, of course, benefits from interest rates staying low, and rates will stay low indefinitely given the Fed's stance.

I do wonder if REITs with good yields are nice bet now.

Commodities prices, of course, are set globally, and China is the biggest consumer in many categories. China has an strong, aggressive growth-oriented central bank, and of course their economy has been on fire for decades.

Who knows the future, but I sense global leadership will shift to Beijing, where they want economic growth, and from Washington DC, with it peevish fixation on fighting inflation, and reliance on irrelevant military power to exert influence.

The works floods with yuan...guess how this story ends up.

Tom L said...

Great article again. I tried to access Don Luskin's report, however it is for only institutional clients. With Larry Kudlow's retirement from his show, I am hoping to find blogs from each of his analysts - that are publicly available - "free". It would be good to see Mr. Luskin provide some public content. Thanks again for your great work.