Wealth Management: Strategy blog – Round one to deflation
Strategy team - Kevin Gardiner (Wealth Management)
Another day, another record
Core consumer prices in the US fell by 0.4% in April. It doesn't sound like a big deal, but it is the largest-ever monthly decline, at least since 1957 (when records for this series began).
To be clear, this was a fall in the level of consumer prices, not in their rate of growth, a subtle distinction often lost on many sub-editors, who can report falls in the inflation rate as falls in prices. This was indeed outright deflation, not disinflation.
And it was a fall in core prices - it was not just a reflection of lower oil and gasoline prices. The headline consumer price index (CPI) fell by more (by 0.8%), but this was only the second-biggest fall since WWII, and it is a less important indicator.
There was only a muted response, but as with the activity data - output, spending, employment - CPIs may have lost some of their ability to surprise. Moreover, year-on-year core inflation is still firmly positive, at 1.4%. But is it an indication of what lies ahead?
Demand has been deficient…
We're not convinced, though our conviction here is less firm than our belief that the falls in activity will start to reverse soon. Even before the suppression of covid-19 took effect, inflation had been remarkably subdued, and its relationship to economic growth was being questioned (as we've noted before). We can imagine a situation in which modest deflation persists even when economies revive. That would not yet be our central scenario, however.
Despite their record-breaking fall in April, the trend in the core US CPI is not far out of line with the rest of the developed world. There are few signs of reviving inflation momentum in the other big economies - including China, where the core year-on-year rate also fell markedly in April, and the eurozone. The immediate impact of the crisis seems to have been to damp inflation even further in most places, as we'd guessed.
The crisis has hit both supply and demand. Lockdowns are stopping people from both working and spending. That said, demand may initially have been hit harder, as consumer and business confidence crumpled independently of spending power. Businesses have been left with unwanted inventories, and unavoidable costs that need somehow to be covered.
More surprising, perhaps, is the fact that statisticians are able even to collect enough data to construct a CPI when so many shops, restaurants, cinemas and so forth have been closed. You can't get your hair cut, or go on holiday, online.
On a longer-term view, however, the outlook is somewhat polarised.
… but will it become excessive?
Some economists expect outright deflation to persist and spread. This is usually because they don't see economies rebounding enough to rekindle demand. Few are willing yet even to countenance the possibility noted above - namely, that deflation could in theory accompany a growing global economy.
Others, however, see big inflation looming. Not because they expect a sustained economic boom - nobody, as far as we can see, is willing to predict that, which ought to intrigue the contrarians out there - but because they see aggregate demand exceeding supply.
The reasons for expecting there to be "too much money chasing too few goods" vary. Mostly, the inflationists see central banks deliberately fostering higher inflation, and succeeding in doing so, as part of a strategy (if only an implicit one) for reducing the burden posed by excessive government borrowing.
Most government and corporate debt is still fixed in nominal terms, and inflation both directly reduces its real value and helps prevent real interest rates from rising to make good the loss.
Some economists however feel that higher inflation is inevitable already, not because of what central banks will do next but because of what they have already done in the last few decades - namely, tolerate growth in financial balance sheets way in excess of the growth in underlying economies.
Our perspective - and conviction
We feel loosely affiliated with the inflationist camp, and within it, the group that worries about what central banks may do next. We do not share the distinctly rose-tinted glasses with which some economists view the era of the gold standard, for example.
As lockdowns are eased, and economies recover - which may be starting to happen as we speak, though we are unlikely to see it reflected in official data for some weeks yet - we think that central banks and governments will be very slow to take away the emergency support that they've put in place.
That support has mostly been directed towards the demand-side of the economy. With private confidence and demand depressed it may not have been felt, but if monetary and fiscal policy stay too loose for too long when confidence recovers it may yet lead to a net increase in effective demand, sufficient even to outpace rebounding supply.
Our worries would be amplified if governments were to print, rather than borrow, more of the money needed to finance their fiscal support (see the earlier post).
A bit more inflation would not be a good thing. We are sceptical it can be fine-tuned even by the cleverest central bank, and worry that the possible damage it could do would dwarf the benefits of deflating a debt burden that we see as manageable to begin with.
For now, the immediate deflationary/disinflationary impact is dominant, as those CPIs show. The inflation expectations priced into bond markets have fallen, in some cases to new lows. The decline in "break even" inflation rates has been greatest for near-term expectations - and for inflation-linked bonds, headline CPIs, including oil prices, are what matter.
Longer-term declines have been more modest, as can be seen reflected in the chart below in the divergence between the break-even rates priced into the next 10 years as a whole, and those priced in for the second half of that period). We remain wary.
Click on image to enlarge
This is the main reason we continue to avoid long-dated conventional government bonds - we're not troubled by government creditworthiness, it's inflation risk that holds us back - and one of the reasons for shunning some of the less diversified emerging markets.
But as we noted earlier, our strongest conviction today concerns not the possibility of more inflation, but the probability of resumed growth.
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