Enough with This Recovery Talk
Courtesy of Rom Badilla, CFA – Bondsquawk.com
As Bondsquawkers know, the bigger concern right now should be deflation risk. We preach this because the issue should be paramount on people’s worry list and should be labeled public enemy number one. FT.com’s Money Supply raises the idea of deflation in this recent blog post but suggests that it is not an issue for now (1). The post states:
With the core PCE and the core CPI running much lower than the Fed’s target range, and lower than expected earlier in the year, some within the Fed are clearly getting nervous that a deflationary spiral could be on the horizon if the economy hits another rough patch, which isn’t out of the question given events in the Euro zone.
But most within the US central bank – even excluding the inflation hawks – are probably still reasonably comfortable that such a scenario will not unfold.
The first reason is that in all likelihood as the economy recovers and the output gap closes, inflation will start to rise at a faster rate.
The economy has yet to prove that this “recovery” is sustainable. Sure, GDP growth for the past two quarters has been encouraging. The mainstream media, analysts, and politicians were showing a sigh of relief earlier and patting themselves on the back as the financial crash train wreck is an image in the rearview mirror. However, most failed to distinguish the difference between economic growth fueled by increases in innovation and productivity and economic growth fueled by increased spending driven by easy access to money. One is sustainable while the other can run only until your pockets run dry. The fact remains that much of the improvement is derived from stimulus programs which at this point in the game is about to run out.
For arguments sake, let’s assume that GDP remains positive and in line with expectations which is running in the mid to low 3 percent range for both 2010 and 2011. Unemployment recently increased to 9.9 percent in April. If we refer back to Okun’s law (2) (named after economist, Arthur Okun in the early 1960’s), which is the empirical economic relationship between the change in the unemployment rate and the change in output or GDP, we can determine the level of output growth necessary to bring down the unemployment rate. Specifically as a rule of thumb, a 1 percent decline in unemployment corresponds to a 2 percent increase in GDP, or vice versa. Following this relationship, the US economy will require higher output and GDP growth, more so than what it is experiencing now, in order to decrease the level of unemployment.
Given where GDP is now and its expected future path of 3-4 percent, unemployment will remain at elevated levels at best, based off of this relationship. Therefore, with people sitting on the sidelines waiting and wondering where their next paycheck will be, there is too much resource slack present in the system to put upward pressure on prices. A system with little demand with too many resources will ultimately lead to a drop in prices and thus the deflation cycle begins.
As David Rosenberg of Gluskin Sheff pointed out in his daily report “Breakfast with Dave” (3), the outlook doesn’t look promising, especially after the recent decline in the equity markets:
The fly-in-the-ointment is that unlike 1987 or 1998, this is not just a financial crisis but one that is occurring with the global economy in a post-bubble fragile state — if it is a recovery, it is a nascent recovery. And, already we see that the U.S. leading economic indicator fell in April, which is unusual at this early stage of the cycle, and jobless claims heading back above 470k, if sustained, is worrisome because in the past this has coincided with job losses fully 75% of the time. By the time the jobless recoveries were over and done with in 2003 and 1993, claims had already moved down to 400k in the former and 350k in the latter. And, practically every house price measure in the U.S.A. is rolling over right now. The lesson of 2002 is that market priced for perfection does not even need a classic double-dip to falter — a simple growth relapse will do the trick.
FT.com further states that inflation expectations will remain subdued by looking back at history:
During the spring of 2008, when soaring commodity prices were sending inflation much higher, inflation expectations remained under control. Likewise they seem to be doing now. Even as inflation is slowing to its lowest levels in 40-plus, inflation expectations are not being affected in a big way.
This only paints half a picture. Inflation expectations were under control in the spring of 2008 because rising commodities were being offset by declines in asset prices. Housing declines and the faltering in the global markets such as China, which were the main drivers of rising commodity prices, tempered inflation expectations as signs of economic weakness started to show through the cracks. At that point, the boom economy was running on fumes as people could no longer use their homes as ATM machines. When housing started to show signs of faltering, credit started to weaken which in turn, started to reign in people’s ability to spend.
Today, not only is housing stagnant, but commodity prices such as copper and other metals are declining as well, along with the boom economies like China and Australia. The two, which were diverging at the onset of the recession, are now going in the same direction which is pointing down. With little signs of improvement anywhere and confidence declining, inflation expectations will begin to shift downward. With the inflation rate currently at dangerously low levels, there is little reason for optimism as the cushion gets smaller and smaller.
The problem I see here with FT.com’s opinion, which up until recently was shared by many others, is the lack of urgency of the current situation. As Ben Bernanke wrote in 2002 when he was a Federal Reserve Governor, the best way to defend against deflation is to avoid it at all costs. Once a deflationary mindset sets in, it is extremely difficult to break. Just ask the Japanese about their “Lost Decade” that is approaching 20 years. With inflation running at 1 percent, federal stimulus wearing off coupled with fears of another credit crunch due to the European debt crisis, there is very little room for error. Time for action is now. Simply put, time just like prices, is running out.
