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Central Bankers Grapple with Deflation Risk

In a period of loose monetary policy and rising liquidity it is no surprise that there is a rise in commodity prices. Both the CRB and JoC commodity indices are rising currently. However the greater surprise perhaps is that economy-wide price pressures remain subdued.

Pessimists would argue that the correlation between commodities’ price inflation and the industrialised countries’ CPI means that it is only a matter of time before inflationary pressures are reignited. But this is clearly not the view at the Fed. At the FOMC meeting on May 7, the minutes noted that the US inflation outlook remained favourable, with nearly all price measures decelerating over the period, that the risk of price pressures intensifying were limited and that inflation might edge lower in the early stages of expansion.

But the pessimistic view is that the rise in commodities prices is a key concern for inflation. Pessimists can also cite the rise in the prices component of the ISM/NAPM index.

However there is little correlation between the ISM/NAPM prices index and the growth rate of producer price inflation. In fact, astonishingly, the ISM/NAPM prices index appears to be a lagging indicator of PPI inflation.

Crucially, throughout any business cycle there are a number of factors which may prevent the pass-through of price rises. Of these, decreased purchasing power of final demand can be a determining factor for the price level, along with the intensity of competition. It has been noted recently that final demand in the US economy, the engine of world growth, has been slowing. In terms of the intensity of competition, you don’t have to be involved in the current price war amongst US auto producers to understand that price competitiveness remains ferocious.

The rate of capacity utilisation is a reasonable proxy for the intensity of competition amongst producers; marginal sales become decisive for maintaining turnover. It is possible that the rate of capacity utilisation and the year-on-year growth rate of PPI inflation have bottomed. But there is no evidence to suggest that either the utilisation rate or the PPI are about to make sudden or exaggerated moves higher.

In addition, there are some leading indicators which suggest that price pressures are set to abate even in the field of commodities. At the very least, the profit margins of commodity-related stocks are under increasing pressures, which may be taken as further evidence of the inability to pass on price rises.

The performance of the commodity-related stock members of the S&P 500 has been very poor and is frequently a lead indicator for the level of US PPI. The downtrend in the former is a clear pointer to further deflationary pressures.

It should be stressed that the downtrend in prices is not confined to the US economy but is evident across the main industrialised countries. Disinflation, and in some cases outright deflation, is the actual trend in the leading economies.

The combination of global excess capacity and the declining purchasing power of final demand is a recipe for deflation. This is a topic that researchers at the Fed have recently grappled with in a widely-aired paper, “Preventing Deflation: Lessons From Japan’s Experience in the 1990s”.

For many market participants, the most relevant fact is that any semi-official voice is willing to draw an analogy, even implicitly, between the current situation in the US economy and Japan at the beginning of the 1990s.

For the researchers, there are two key conclusions. Firstly, as both price inflation and interest rates tend towards zero, the risk of deflation rises. This may seem self-evident, but the key here is that interest rates are limited to zero, while inflation is not, thereby raising the spectre of rising real interest rates even when the nominal level is at zero (and obviating the ‘Taylor Rule’). Secondly, in order to minimise the deflationary risk, the fiscal and monetary policy must be complementary in order to offset deflationary tendencies.

It is almost certainly right to interpret this research as a clear hint both that interest rates are set to remain low and that there is little concern at the Fed that fiscal policy is too stimulative. On the contrary, it seems as if, based on the analogy with Japan, any misalignment of fiscal and monetary policy exacerbates the risk of deflation, especially when both inflation and interest rates are already low.

It is also important to note the motivation for the research and what may have prompted it. Crucially, the performance of the stock markets in the US is unprecedentedly poor during a Fed easing cycle, and a three-year decline in stocks (which now seems likely) has only previously occurred during war or following 1929.

This, of course, is exactly a key problem that has plagued Japan for over a decade, not least because liquidity creation did not lead to increased monetary circulation. However, that may be about to change. There is now a possibility that the BoJ medicine may finally begin to work. This would also have a major impact on the level of the yen, not only keeping domestic investors at home, but potentially attracting foreign stock buyers. The great irony would be that, just as the Fed begins to fret about deflation, the great exemplar of deflation may be just about to prise itself out of the trap of falling prices.

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