Deflation, Inflation, the Fed, and the Gov’t
November 24 – December 5, 2008
Minutes of the October 28-29 policy meeting showed that some Fed officials were worried about deflation. On the other hand, a number of financial market observers have worried that, through expansionary policies, the Fed and the government may be fueling future inflation. Why is deflation a worry, and what can the Fed do about it? Looking further ahead, what is the risk of renewed inflation when the economy eventually recovers?
Deflation refers to a general decline in the price level of goods and services (as opposed to disinflation, which is a decline in the inflation rate). There is big difference between short-term deflation (a brief decline in prices) and long-term deflation (a sustained rate of decline in the overall price level). The U.S. economy has experienced deflation in the past, but not in a very long time. When we speak of “deflation,” we are usually talking about the long-term variety, such as occurred in Japan in the 1990s or in the Great Depression. Currently, the deflation we see appears to be the short-term variety, fed by an unwinding of the prices of energy and other commodities. Nevertheless, there is fear that the weakening global economy could generate a more severe and longer-lasting decline in the price level. The odds of a more significant deflation are still low, but are somewhat higher than a few months ago.
Why is deflation a bad thing? In deflation, consumers are better off postponing purchases. Why should I buy now, when what I want will be cheaper in a month or two? Hence, consumer spending will be a lot weaker. Borrowers will have to pay back loans in dollars that are worth more than what was borrowed, so they become reluctant to borrow. Returns on business investment will be in lower-valued dollars. Hence, firms will be reluctant to expand. Overall growth will be weaker – and weak growth will help push prices down further – leading to a deflationary spiral.
The Fed faces a major problem in fighting deflation. It cannot lower rates below 0%. There is no scope for traditional monetary policy to stimulate the economy. What can the Fed do? Milton Friedman suggested that the monetary authority could simply drop money from a helicopter. More realistically, the Fed can bypass credit intermediaries and lend directly to consumers and businesses. Such quantitative easing is already being done to some extent at the Fed. For example, through the Commercial Paper Funding Facility (CPFF), the Fed purchases unsecured and asset-backed commercial paper directly from eligible issuers. At some point, the Fed could purchase Treasury securities, mortgage backed securities, or even corporate bonds.
The government can also assist in fighting deflation though stimulus efforts. John Maynard Keynes jokingly suggested that the Treasury could place money in old bottles and bury them in disused coal mines, leaving it to private enterprise to dig them up. Realistically, more thoughtfully planned stimulus would be effective in boosting overall growth to the point where deflation is no longer a problem. Spending on the transportation sector, such as the repair of roads and bridges, would take some time to implement. Tax cuts are another form of fiscal stimulus. Barack Obama promised lower taxes for the middle class, and these are likely to be pushed through quickly by the new administration and Congress.
This raises the question of whether monetary and fiscal stimulus will eventually lead to higher inflation when the economy recovers. That’s not a big worry. There is currently plenty of slack in the global economy and it will be some time before we see inflation fueled by strains on resource utilization. Commodity prices are retreating and there’s no inflation coming out of the labor market. The money supply has increased rapidly, but the velocity, or turnover, of money has decreased. Should a miracle occur, and the economy recovery more rapidly than anyone expects, the Fed can begin to remove its monetary policy accommodation. The government can scale back as well – in fact, other than the middle class tax cuts, most government stimulus efforts will be designed to have a limited shelf life (the idea is to get the economy through a tough patch, prime the pump, but not create permanent make-work projects.
While serious deflation is a low risk, it is a possibility. The bigger worry is the slowdown in global growth. Efforts to support economic growth through monetary and government efforts will continue both here and abroad. These efforts should support growth by the end of the year. However, the global economy remains in panic mode for the near term. Things will get worse before they get better, but they will get better.
A Possible Endgame To The Recession
November 17 – November 21, 2008
Financial market volatility has remained extremely high in recent weeks. Large swings with no clear direction are indicative of the high level of uncertainty in the economic outlook. How severe will the current downturn be? How long will it last? Nobody knows. The consensus view among economists is that the current quarter will be terrible, weakness is likely to extend into early 2009, but global policy efforts should help support growth later next year. That said, the risks are still tilted toward the downside. What factors will make the hopeful forecast into a reality?
It doesn’t look good for the consumer. Inflation is coming down sharply, but real wages are still lower than a year ago. The loss in housing and stock market wealth will restrain spending, all else equal. Tight credit isn’t helping. The weak job market is not good. Beyond these impacts, consumer spending habits may be undergoing a sea change as they begin to save more.
The biggest driver of consumer spending is income growth. Adjusted for inflation, year-over-year wage growth turned negative earlier this year. Higher energy prices pushed real wages even lower through the summer. Since mid-July, energy prices have retreated significantly. Gasoline prices are about half of what they were at the peak. The drop in gasoline prices leaves consumers with more money to spend on other things. However, the impact arrives with a lag.
The wealth effect on spending is small. An extra $100 in wealth might result in $3 or $4 in additional spending. It’s a small effect, but changes in wealth are sometimes large. Moreover, the impact on spending is likely asymmetric. That is, consumers respond differently to increases in wealth than they do to declines. For those who have been in their homes for more than five years, the housing price correction is not that big of a deal. For recent buyers, it’s a huge problem.
The drop in home prices has made it harder to get a home equity line of credit. The extraction of home equity had been a strong force supporting consumer spending growth in recent years. However, credit is now tighter. The Fed has cut rates significantly, steepening the yield curve, which gives banks more incentive to lend. However, the Fed’s most recent survey of senior loan officers showed that banks further tightened terms and standards on consumer loans over the three months ending in October. Last week, the Fed, Treasury, and FDIC issued a statement that they “expect all banking organizations to fulfill their fundamental role in the economy as intermediaries of credit to businesses, consumers, and other creditworthy borrowers.” Such moral suasion has had mixed results in the past, and one can understand the reluctance to make loans in the current environment. However, over time, banks should begin to relax their lending to consumers.
Meanwhile, the job market has been falling apart at an increased pace. More than half a million people filed initial claims for unemployment insurance benefits in the latest week. The number receiving benefits is the highest in more than 25 years. Layoffs are going to get a lot worse before they get better.
Perhaps the greatest concern is that consumers may be adjusting their spending habits too sharply. It’s good that people save, but it’s bad when everybody tries to save more at the same time. In saving more, households would be spending less – and, since consumer spending accounts for 70% of GDP, overall economic activity would be a lot lower. There are signs that households not directly effected by job losses or tighter credit are cutting back, reducing discretionary spending. Whether this is a short, transitional phase or a deeper and longer-lasting trend remains to be seen.
So what will it take to get out of this mess? When times are bad, many assume that they will never get better. First, oil prices must remain low or fall further. Banks must begin to relax terms and standards for consumer loans. The adjustment in consumer spending habits (that is, increased saving) needs to be spread out more gradually over time. The Fed and other central banks appear likely to cut interest rates further. We should see further large-scale government efforts to stimulate the economy, either in the lame duck session or under the new administration and Congress.
There appears to be limited upside to the hopeful outlook, and the downside risks are considerable, particularly if consumers continue to retrench. However, the policy responses here and abroad have been swift and large – and there’s more to come. Despair is easy. Hope is hard, but not impossible.
The opinions offered by Dr. Brown should be considered a part of your overall decision-making process. For more information about this report – to discuss how this outlook may affect your personal situation and/or to learn how this insight may be incorporated into your investment strategy – please contact your financial advisor or use the convenient Office Locator to find our office(s) nearest you today.
All expressions of opinion reflect the judgment of the Research Department of Raymond James & Associates (RJA) at this date and are subject to change. Information has been obtained from sources considered reliable, but we do not guarantee that the foregoing report is accurate or complete. Other departments of RJA may have information which is not available to the Research Department about companies mentioned in this report. RJA or its affiliates may execute transactions in the securities mentioned in this report which may not be consistent with the report's conclusions. RJA may perform investment banking or other services for, or solicit investment banking business from, any company mentioned in this report. For institutional clients of the European Economic Area (EEA): This document (and any attachments or exhibits hereto) is intended only for EEA Institutional Clients or others to whom it may lawfully be submitted. There is no assurance that any of the trends mentioned will continue in the future. Past performance is not indicative of future results.
