Friday, April 16, 2010

Despite Massive Liquidity, Inflation Stays Low

After March's very low consumer price growth, some analysts are revisiting the idea of short-term deflation. However, others argue that the massive liquidity that has been injected into the financial system is a much greater concern. See the following post from The Capital Spectator.

Today’s update on consumer prices for March suggests that inflation remains tame. Is it too tame?

Some analysts think so. In fact, worries over deflation are again popping up in economic discussions. Didn’t we thrash the deflation beast last year? Maybe not. One reason for thinking that inflation is the bigger threat in the years ahead is the massive reflation program that’s been job one at the Federal Reserve, aided and abetted by the profligacy of fiscal policy.

Does the ambitious government’s ambitious efforts in money printing since 2008 threaten higher inflation? Not necessarily, opines Paul Davidson, editor of the Journal of Post Keynesian Economics. In his latest book The Keynes Solution, Davidson argues that merely printing money in and of itself isn’t a sure path to higher inflation. Drawing on Keynes, he minimizes the potential threat of inflation and warns against “knee-jerk” reactions for predicting pricing pressures.

Based on today’s CPI report, at least, there are no official signs of rising inflation at present. Consumer prices rose just 0.1% last month, the government reports. That’s up ever so modestly from February’s report of flat prices. For the 12 months through March 2010, CPI advanced by just 2.2%. That's up from the outright deflation in the year-over-year numbers posted for much of 2009. But is deflation again a growing concern? Some analysts think so.

There is a “near-term risk of flipping to deflation given our view that developed economies have not fully healed and consumers are not yet ready to stand on their own two feet,” advises Mihir Worah, manager of the $18 billion Pimco Real Return Fund. As he explained on Pimco’s web site, “to the extent central banks continue their quantitative easing programs then clearly they are once again truncating the deflationary tail and we can anticipate a successful reflation of the economy. But any meaningful inflation should still be a couple of years away.” Asked if the rise of sovereign debt around the world threatens higher inflation or deflation, he responds:
The answer to this depends on the timeframe and on the country in question. In general, there are essentially three ways out for countries that cannot service their debt: The first is to grow their way out of it, the second is to default on their debt, and the third is to inflate their way out of it. Which option is selected is really country- and region-specific.

Countries such as the U.K. and the U.S., which have their own fiscal issues, clearly aren’t going to default on their debt. They issue debt in their own currency and control their own monetary policy. Hence, in the longer term, inflation is a likely solution to deal with their inability to grow their way out of persistent deficits. However, in the eurozone, you’re faced with a very different situation where countries like Greece cannot issue debt in their own currency. They cannot debase their currency, which makes their economy more competitive, and so it is unlikely that they can grow their way out of it. So the only possible outcome (other than an outright default) is fiscal belt-tightening and reduction of input (labor costs) in order to make the goods and services they produce more competitive – and this is deflationary. We are already seeing signs of this. Countries in Europe with the worst fiscal situations that have started the tightening process, like Ireland and Spain, are already showing strong signs of deflation and we expect to see deflation in Greece as well.

To summarize, countries that cannot grow their way out of the problem and do not have their own currency that they can debase are more likely to see deflation. Meanwhile, you should expect to see the opposite effect in countries like the U.S. and U.K., which issue debt in their own currencies.

Worrying about deflation has also crossed the minds over other analysts recently. "We're looking at an economy that's dangerously close to deflation," Ethan Harris, chief economist at Bank of America Merrill Lynch, tells The Wall Street Journal. The D word is also popping up in various spots around the blogosphere. “The Europeans are heading right into the den of a deflationary trap,” according to Roseman Eruptions. “At a time when most of the world is still supporting an economic recovery plan to boost growth following the darkest days of the credit crisis, the Europeans seem bent on fighting inflation.”

Nonetheless, with all the liquidity sloshing around the world, it’s too soon to dismiss inflation as a real if not necessarily present danger. "I don't think we should be complacent about inflation risk,” Fed governor Kevin Warsh said last week. "Inflation expectations will be anchored until they are not."

In fact, some investment strategists are anything but pessimistic about the prospects for the global economy. Ed Yardeni and his research team at, for instance, advise in a note to clients today that the outlook for a robust rebound—a “V-shaped recovery”—appears to be in the offing. “That’s what industrial commodity prices are predicting again,” they write. “The CRB Raw Industrials Spot Price Index, which is one of our favorite indicators of global economic activity, is rallying again, more than reversing the loss posted earlier this year.” The note goes on to explain,
In a sign the global economy is emerging from its downturn, the value and volume of world trade, along with global production, are up from 2009 lows, and trending higher. The value of trade has turned down, but remains on uptrend. Renewed strength in commodity prices suggests the global recovery remains on track.
At the moment, it seems that we can’t dismiss deflation or inflation as a potential hazard. In the long run, inflation is surely the bigger problem. But in the course of getting from here to there, the road may run through a fresh tussle with deflation. What’s a strategic-minded investor to do? The default approach is considering both sides of the pricing equation and hedging against these twin demons of potential risk. Unless you have an unusually high degree of confidence about the future, it seems prudent to guard against deflation in the near term and inflation further on down the road.

In short, it’s still too early to abandon allocations to Treasuries or to commodities, each of which represent a hedge on inflation and deflation risks, respectively. There are other hedges, of course. One can argue that equities will benefit from inflation as a long-term proposition by way of earnings growth above the rate of general inflation. The precise degree of how to structure such a dual allocation is debatable, of course. But the general concept seems well founded, at least for the moment.

The larger point is that we seem to live in bifurcated world with respect to the outlook on pricing trends. Or as the ETF Database advises, “Forget The Inflation/Deflation Debate: The Real Threat Is Biflation.”

This post has been republished from James Picerno's blog, The Capital Spectator.

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