Deflation feeds global fears.

Was the taper a mistake?

Risk of Deflation Feeds Global Fears
By JON HILSENRATH and BRIAN BLACKSTON

Updated Oct. 16, 2014 12:01 p.m. ET

Behind the spate of market turmoil lurks a worry that top policy makers thought they had beaten back a few years ago: the specter of deflation.

A general fall in consumer prices emerged as a big concern after the 2008 financial crisis because it summoned memories of deep and lingering downturns like the Great Depression and two decades of lost growth in Japan. The world’s central banks in recent years have used a variety of easy-money policies to fight its debilitating effects.

Now, fresh signs of slow global economic growth, falling commodities prices, sagging stock markets and declining bond yields suggest the deflation risk hasn’t gone away, particularly in the often-frenetic eyes of investors. These emerging threats come as the Federal Reserve is on track this month to end a bond-buying program that has been one of the main tools in its fight against falling prices.

The deflation concern is particularly pronounced in Europe and Japan, two economies where policy makers are struggling to come up with solutions to counter especially slow economic growth.

However, recent declines in commodities prices suggest that downward pressure on inflation—if not all-out deflation—could become a wider-ranging phenomenon, and one with some mixed implications for economies like the U.S. and emerging markets.

Investor worries about the global economy appeared to gather force Wednesday. European stock markets sagged; the Stoxx Europe 600 index fell 3.2% to its lowest level since last December. U.S. stocks pared steep losses, but still finished down for the fifth straight day; after falling more than 450 points at one point, the Dow Jones Industrial Average fell 173.45, or 1.1%, to 16141.74.

Meantime, yields on 10-year U.S. Treasury notes fell to 2.091%, their lowest level since June 2013, and are down nearly a percentage point from the beginning of the year. Bond yields fell to new lows in Germany, too. Crude-oil prices dropped further; crude futures on the New York Mercantile Exchange fell to $81.78 a barrel, the lowest level since June 2012.

The deflation concerns are particularly acute in Europe, where annual inflation in the 18 nations that use the euro was 0.3% last month, a five-year low that is far below the European Central Bank’s target of just under 2%.

With inflation so low, it wouldn’t take much of a shock—such as weakness in Germany’s economy or geopolitical tensions in nearby Ukraine—to tip the whole region into a deflationary downturn. Some eurozone countries, such as Italy, have already tipped into deflation. Even countries outside the currency bloc are feeling the pain. Sweden’s statistics agency said Tuesday that consumer prices fell 0.4% in annual terms last month after a 0.2% fall in August, well below its central bank’s 2% target.

The risk of deflation in Europe is “a real worry,” Harvard University professor and former Federal Reserve governor Jeremy Stein said in an interview. “The right prescription [for policy makers] is to be aggressive.”

ECB President Mario Draghi acted against deflation risks in June and September, pushing the central bank to slash interest rates to record lows each time—including a negative rate on bank deposits at the ECB—and unveiling new bank-lending and asset-purchase plans for asset-backed securities and covered bonds.

But there is little consensus for more-dramatic measures—the kind of monetary stimulus the Fed, the Bank of England and the Bank of Japan have deployed—namely large-scale purchases of government bonds to raise the money supply.

The head of Germany’s central bank, Jens Weidmann, has signaled his opposition to such bond buying, and other members of the ECB’s governing council appear sympathetic to his argument that with government and corporate borrowing costs already superlow, the policy wouldn’t even do much good.

“I am very much for a steady-hand approach, and I think this is what we are doing,” Austria’s central bank governor, Ewald Nowotny, said in an interview last week.

Hard fiscal problems are part of Europe’s problem. Last week, Standard & Poor’s stripped Finland of its triple-A credit rating and downgraded France’s outlook. On Tuesday, Fitch put France on review for a possible downgrade.

Struggling economies such as France and Italy face a tough choice: Take additional austerity measures to shrink budget deficits, inflicting more pain on their economies, or attempt to flaunt the EU’s budget rules calling for low deficits, which could damage their credibility in Europe.

The resistance Mr. Draghi faces has shaken the faith of some investors that policy makers in Europe will address the threat.

“Market valuations, especially for rich countries, have been well above what was warranted by fundamentals. What kept them up there was a belief that central banks were markets’ best friends,” said Mohamed El-Erian, chief economic adviser at Allianz Group. “Most people now recognize that the ability of central banks to address what ails the global economy is weaker than they believed.”

Meanwhile, Japan had recently begun to stir sustained growth, which helped to push its inflation rate above 1%, after years of on-again, off-again deflation. But inflation decelerated again in recent months as the economy softened after an April sales-tax increase meant to restrain mounting government debt. Many private economists forecast a slip back below 1% this year.

Japanese officials must now decide whether to follow through on another planned sales-tax increase that could dent growth even more. And the Bank of Japan is weighing whether it needs to provide even more stimulus. BOJ Governor Haruhiko Kuroda launched new asset purchase programs last year to reverse two decades of deflation and has pledged to persist until he reaches the 2% target.

Japan’s struggles to exit deflation, even with massive central-bank stimulus, illustrate just how difficult it is for an economy to pull out of the trap, once it has settled in.

A weak global outlook “has to be a worry for every economy,” Reserve Bank of India Governor Raghuram Rajan told The Wall Street Journal in an interview last week.

The U.S. confronts much different circumstances than Europe and Japan. U.S. inflation had been rising toward the Fed’s 2% objective earlier this year but now faces a downward tug amid the weakening global growth and a strengthening U.S. dollar. The Labor Department reported Wednesday that producer prices in the U.S. fell in September. Sharp drops in commodities prices this month could add to downward pressure.

Yet falling commodities prices have silver linings. For one, the decline is being driven in part by a U.S. energy production boom—not just sagging global demand for goods. Moreover, falling gasoline prices are a boon to U.S. consumers: One rule of thumb is that every one-cent drop in the price of gasoline amounts to a $1 billion boost to U.S. household incomes, and gasoline prices have dropped by 13 to 17 cents from a year ago, according to the automobile group AAA.

“All else equal, when energy gets cheaper, we benefit,” Mr. Stein said.

Meanwhile, the Fed is on track this month to end its bond-buying stimulus program launched in September 2012. And Fed officials have largely stuck to their line that they expected to start raising short-term interest rates by the middle of 2015. Still, traders in futures markets have been pushing up the prices of contracts tied to the Fed’s benchmark interest rate—a sign they see diminishing odds that the Fed will follow through on that plan.

Harvard’s Mr. Stein said he didn’t think the U.S. central bank needed to alter its thinking much in light of recent developments. “I wouldn’t dramatically revise my expectations,” he said. “The balance of the job-market news in the U.S. has been very positive.”

A Commerce Department report Wednesday showed U.S. retail sales dropped in September, but many economists are sticking to estimates that the U.S. economy expanded at a rate in excess of 3% in the third quarter, potentially the fourth time in the past five quarters it exceeded 3%. Moreover job growth has been stronger than Fed officials expected.

anchored perceived inflation

I asked in comments for DeLong to add Waldmann's post on "anchored perceived inflation" and he did.

Menzie Chinn has a related post.

And here's DeLong's post on Chris House and Krugman from a week ago.

Phillips curves with anchored expectations by Robert Waldmann (from July 1st)

deflation threat

Now is the time to preempt deflation by John H. Makin (American Enterprise Institute)

Explainer: Why is deflation so harmful? by Mark Thoma

deflation

A sign of the times? Conservatism and denial of reality.

Bitcoin's deflation problem by Ryan Avent

TWO weeks ago we published a Free exchange column examining whether Bitcoin could be considered a true money, and if not, why not. Mike Hearn, one of Bitcoin's most prominent software developers, responded to the column somewhat dismissively. I wrote an e-mail response to Mr Hearn, the gist of which I will reproduce here. He makes two broad criticisms. The first is that we have lazily repeated the argument that deflation will kill Bitcoin, which in his view has been debunked. And the second is that we are naive to think put much faith in official inflation statistics. 

I think Mr Hearn may have misunderstood the piece's argument. It was not that deflation would kill Bitcoin. Rather, it is that deflation will prevent Bitcoin from becoming a unit of account, and that, in turn, will keep it from displacing traditional currencies. But Bitcoin could survive and indeed thrive without becoming the coin of the realm. 

The issue, as the piece explains, is that deflation in the unit of account leads to unemployment, thanks to the fact that wages generally don't adjust downward. Mr Hearn suggests that the idea that deflation might be costly is controversial among economists. I must disagree; it really isn't. Economists would love it if he were right that deflation didn't matter—that money, in economists' parlance, is neutral. If wages adjusted quickly and cleanly then they could go back to applying really straightforward classical economic models and everyone's life would be simpler. But the data are very clear on this point; wages are "sticky", and so deflation in the currency in which wages are set is costly.

(emphasis added.)

Baker has a contrarian take which has some truth to it.

NGDPLT: the guard dog you want

For David Andolfatto: why I switched from IT to NGDPLT by Nick Rowe

We had three guard dogs, named IT, PLT, and NGDPLT, that were all saying about the same thing from 1992 to 2008. The Bank of Canada listened to the first of those three dogs, and things seemed to go pretty well. So we figured IT was a good guard dog. In 2009 things changed. The Bank of Canada kept on listening to the IT dog, and did what was needed to make sure the IT dog stayed fairly quiet. The PLT dog stayed fairly quiet too. But the NGDP dog started barking loudly, telling us that monetary policy was too tight. And when I looked out the window, I saw exactly those symptoms that I normally associate with a random tightening of monetary policy: people having greater difficulty selling things for money; greater ease buying things for money; and a fall in the quantities of things sold for money. I saw exactly the same sort of recession I would expect to see if monetary policy suddenly at random became too tight. The NGDP dog was right to start barking loudly; the IT and PLT dogs failed to warn us of the recessionary burglar.

So I say: get rid of the IT dog and start listening to the NGDPLT dog instead.

[Update: and raising the inflation target is like giving the IT dog a hearing aid in the hope it will do better; and switching to a temporary NGDPLT but only during a recession is like having the NGDPLT dog temporarily replace the IT dog when you already know there's a burglar in the house.]

In comments he writes: "Fiscal policy: given standard arguments for Barrovian tax-smoothing, plus diminishing marginal benefits to government expenditure, I would be wary of distorting micro-optimal fiscal policy to make it do a job that monetary policy should be able to handle."

I would share objections others have on fiscal policy. Multipliers. Implications for inequality and fairness. During downturns the government can make needed infratstructure repairs on the cheap. Also politics. The Fed has become a lightening rod - even with its lackluster performance - because of Congress and austerity.

Tipping point and equilibrium

What Gives? Has the Market Stopped Loving Inflation? by David Glasner

Low Inflation Is the Same Sort of Problem as Deflation by Dean Baker

Crisis Withdrawal Syndrome by Krugman

Oh, since I’m praising Dean, let me say that while it’s true that he has for a long time been making the case that low inflation is a problem even if it’s not actual deflation, his implication that I’m saying this for the first time is a bit unfair. In the European context, in particular, I’ve been beating this drum for a while.

 Krugman has emphasized deflation and the liquidity trap and the press have echoed what the Fed and Bernanke say about deflation being a bad thing. Baker has made the fair point that sup-par inflation is just as bad as deflation.

We'll see if Japan can get out of deflation and if the U.S. or Europe can get out of low inflation.

More Thoughts on Job Creation in the Recovery by Dean Baker

That being said, as the NYT points out, other countries have done better. Germany stands out in this respect, having seen a sharp rise in its employment to population ratio since the beginning of the downturn, and a decline in its unemployment rate of 5.4 percent, in spite of a recovery that has been no stronger than in the United States. 

Part of Germany's story is a slower rate of growth of its labor force, but the main part of the story is work sharing and other policies that encourage employers to keep workers on the payroll, even if they work fewer hours. These policies have been remarkably successful in shielding German workers from the worst effects of the downturn. 

So to sum up, the main reason that so many people are unemployed four years into the recovery is weak GDP growth. This was predictable given the nature of the downturn. Given the weakness of this growth, the U.S. has done a pretty good job creating jobs. However other countries, most notably Germany, have done much better in translating weak GDP growth into jobs and they provide important lessons to the United States.

More on missing downward price pressure (hint, blame corporate profits) by Josh Bivens

But, I’d also note something else holding up prices—the determination of the corporate sector to earn historically high profit margins. The Bureau of Economic Analysis (BEA) has a great table on prices and unit labor and profit costs for the non-financial corporate sector, which accounts for just about half of the U.S. economy. In the NFC sector, prices per unit of output since the end of the recession are up just 4.1 percent. But labor costs per unit of output are down by 1.1 percent. Given that labor costs are more than 60 percent of overall prices in the NFC sector and that they’re falling, this must mean some other cost component in the production process with a much smaller share is rising a lot to drive prices up.

Meet corporate profits per unit—up 63 percent (60 percent after-tax) since the recession’s end. In fact, the growth in after-tax corporate profits can explain all of the 4.1 percent price increase between the end of the recession in the middle of 2009 and the end of 2012 (see the figure below for a breakdown).

There are many good reasons to think that upward pressure on prices is a useful thing in the U.S. economy right now, but I’m not sure that rising profits is one of them.

(via Thoma)

Fed Fail

I.M.F. Warns of ‘Sizable Risk’ of Deflation in Euro Zone 

The International Monetary Fund warned Wednesday of “a sizable risk” of deflation in the euro zone, and called on the European Central Bank to begin buying huge amounts of government bonds to help hold down borrowing costs for troubled countries. 

In a report on the state of euro zone policy, I.M.F. staff said there was a 25 percent risk of consumer price deflation before 2014, and that the danger was greatest in countries like Italy where growth is slow and tax increases have made inflation appear higher than it really is. 

Deflation, a destructive decline in prices that can be extremely difficult to reverse, would make it even harder for countries like Greece, Italy and Spain to get government debt under control, the I.M.F. said, because falling prices and wages would further depress tax receipts.

Bernanke to Economy: Drop Dead by Yglesias

Price Data Suggest Specter of Deflation in China

Krugman writes about how sticky prices are the prices to worry about, not volatile price.

He blogs about it here too.

Of Turning Japanese

A scary chart from Mary Daly, vice president of the Federal Reserve Bank of San Francisco. (via Krugman, via Mark Thoma)

Brad DeLong doesn't believe the QE2 will be enough. (sorry no link) Dean Baker argues that we are already - as they used to say in Vietnam - in the shit. (sorry no link) If we cross past zero, it won't mark anything new just that we are continuing our descent of disinflation. The point when we entered a Keynesian situation is where we crossed the rubicon.

What is needed is a larger QE and more fiscal stimulus.

Democrats, the election, the stimulus and Keynes by Sewell Chan

But that seems unlikely, as long as the recovery plods along slowly. "It would be a mistake to attribute the distancing from Obama’s stimulus entirely to political caution or opportunism," said Robert S. Weisbrot, a historian at Colby College. "As much as those factors may be important, it is dismaying how little evidence there is to show for it. Maybe we need even more, but surely $800 billion should have counted for something"

Krugman blogs

During the pre-crisis period, spending grew slightly faster than GDP --that’s Medicare plus the Bush wars -- while revenue grew more slowly, presumably reflecting tax cuts.

What happened after the crisis? Spending continued to grow at roughly the same rate -- a bulge in safety net programs, offset by budget-slashing at the state and local level. GDP stalled -- which is why the ratio of spending to GDP rose. And revenue plunged, leading to big deficits.

But I’m sure that the usual suspects will find ways to keep believing that it’s all about runaway spending.

What the usually good Sewell Chan fails to report is that the much of the stimulus was ineffective tax cuts and that much of the rest was canceled out or negated by the anti-stimulus of the 50 state governments and the stalling of GDP growth. Currently the economy is growing too slow to create enough jobs and aggregate demand which is why we'll see more action from the Fed.