Deflation, Not Inflation Is A Real Risk

Morgan Stanley - Steve Roach

Financial markets are unprepared for another deflation scare. In the event of such a possibility, bond yields could fall sharply further. With today’s inflationary premium in the TIPS market (220 bp) fully 70 bp above the low hit in late 2002, another deflation scare could push yields on 10-year Treasuries through the 3.50% threshold. Earnings would also have increasingly scarce value in another deflation-risk scenario — enough to trigger another sharp sell-off in US equities. Moreover, in a low and falling interest rate climate, the dollar can be expected to come under renewed pressure as currency realignments play a more active role in the coming US current account adjustment. The trickiest aspect of this scenario is the deflation scare, itself. Two years ago, the core CPI slowed to just 1.2% in the six months ending February 2004 before rebounding quickly back toward 2% by the final quarter of the year. For reasons noted above, in the face of a China slowdown, downside risks to the core CPI hint at an outcome that might even go beyond the concept of just a deflation scare. The next time, it may be the real thing. So much for inflation phobia!

Globalization is an amazing process, there are so many permutations of a world sharing a single economy, one has to reconsider both the lessons of history and economic theory. China and the US economic futures are so intertwined, that it's hard to imagine of a circumstance that would justify either side going to war against the other. The economic damage would be devastating to both.
So far, I fail to understand the far left's concern about globalization. Everything I read about it seem to be based on what sounds to me to be a mixture of unfounded conspiracy theories and an assumption that what is good for multi-national corporations CAN'T be good for anyone else.


Complete Article
Global: Inflation Phobia
Stephen Roach (New York)
Inflation appears to be down and out, but there are lingering fears of a comeback. Those fears are based on the closed-economy inflation models of yesteryear. In the timeworn jargon of the dismal science, the “Phillips curve” tradeoff between growth and inflation is still thought to be alive and well. These fears are overblown, in my view. If anything, the risks are skewed more toward another deflation scare rather than a worldwide acceleration of inflation. Financial markets are not aligned with those risks.
America is on the leading edge of this inflation phobia. With labor and product markets tightening, unit labor costs on the rise, oil prices at $60, and an all-powerful Fed-driven liquidity cycle at work, inflation concerns are understandable. Yet those concerns are not being borne out by the data flow. Underlying inflation in the US economy has surprised on the downside yet again. The core CPI has increased at just a 1.2% annual rate in the three months ending June 2005. On a year-over-year basis, core inflation has slowed to just a 2% rate — the weakest comparison since last October.
The skeptics point to lags or statistical noise as key factors behind the recent disinflation — suggesting the likelihood of a reacceleration of inflation in the not-so-distant future. Survey-based expectations data also underscore the perceived upside to US inflation from current subdued levels. According to the early July tally of consumer confidence by the University of Michigan, year-ahead and five year-out inflationary expectations, have held at 3.0% and 2.9%, respectively — both significantly above the actual outcome over the past year. At the same time, market-based measures of inflationary expectations are hardly at their lows. The spread between nominal yields on 10-year Treasuries and their TIPS-based counterpart — a good proxy for gauging the ups and downs of inflationary expectations — currently remains about 220 basis points. While that’s at the lower end of the range that has prevailed since early 2004, it is far above the lows of less than 150 bp hit in late 2002. Consequently, whether it’s survey- or market-based, the fear of inflation remains a very real and active concern.
A decomposition of recent trends in America’s CPI enables us to better assess the validity of those fears. For purposes of analysis, I will focus on the core CPI — not because food and energy are unimportant in any way whatsoever but because their volatility tends to obscure underlying trends. Key, in my view, is a dichotomy that has emerged between two major pieces of the core — commodities and services. While the inflation rate for core commodities remained extremely low at 0.4% y-o-y in June 2005, that actually represents a sharp turnaround from the outright deflation rate of -2.6% hit during late 2003. Relative to that low, the core commodity inflation rate has accelerated by three percentage points. Services inflation, by contrast, has been on a more stable disinflationary downtrend over the past dozen years, or so. In June 2005, core services inflation was 2.7% — only fractionally above the 2.5% cycle low hit in February 2004 but fully 1.4 percentage points below the cycle high of 4.1% hit in February 2002. Services account for fully 72% of the core CPI — about 2.5 times the share of commodities. That weighting, in conjunction with the recent shift in the mix of the core CPI inflation rate, allows us to conclude that the recent disinflation in the US has been concentrated far more in services than in commodities.
America’s disinflation saga becomes even more interesting as we peer behind recent trends in services. The bulk of the downtrend has been concentrated in three major categories — shelter, transportation, and a hybrid category that includes a broad array of miscellaneous services. By contrast, there has been little relief in the inflation of medical care and household operations services. Of all these pieces, the one that fascinates me the most is the miscellaneous, or “other,” services inflation; in June 2005, this component of core services held at its cycle low of 2.5% — down markedly from the cycle high of 4.1% hit in November 2001. This grouping, which has a weight of about 19% in total core services, includes items such as IT services, personal care services, and legal and financial services — most of which are now exposed to the new globalization of nontradables (see my 7 June 2005 essay, “The New Macro of Globalization”). I don’t think it’s a coincidence that the most disinflationary piece of services inflation is that which is now most exposed to international competition. Moreover, there is still an important domestic force at work in services — namely, that recent wage disinflation has been increasingly concentrated in America’s vast services sector (see my 8 July dispatch, “Back to the Drawing Board”). Over the 24 months ending in March 2005, nominal compensation growth in private service producing industries averaged 3.4% at an annual rate, or just 0.9% in real terms. That works out to only about half the 1.75% pace of real compensation growth in manufacturing over that same period. The combination of globalization and reduced domestic cost pressures underscores the distinct possibility of more disinflation to come in labor-intensive services.
But what about the other pieces of the US inflation puzzle — namely, rising unit labor costs, higher oil prices, and mounting non-oil input inflation? First of all, there can no mistaking the recent deterioration on all of those fronts: Unit labor costs were up at a 4.3% y-o-y rate in 1Q05 — the sharpest increase since 2000. Moreover, input inflation as approximated by the core PPI (2.6%) is now running above core CPI inflation (2.0%) for the first time since 1990. Meanwhile, real oil prices are back to levels last seen in the early 1980s. However (gulp), this time it truly is different. I completely agree with Dick Berner that the old cost-mark-up models of the past have been rendered all but obsolete by the increasingly powerful forces of globalization (see Dick’s 3 June 2005 dispatch, “Inflation Model Uncertainty”). Price setters are no longer in the United States but, instead, they reside increasingly in Shanghai, Bangalore, Seoul, Mexico, and Eastern and Central Europe. As such, domestic cost pressures are no longer synonymous with accelerating inflation as they were in the pre-1990 era. Instead, costs now bear more directly on domestic profit margins. The ups and downs of the inflation cycle in open economies such as the US are increasingly an outgrowth of the global balance between supply and demand.
Against this backdrop, there could be some surprising twists and turns on the US inflation front over the next couple of years. Most importantly, the dichotomy between commodities and services hints at the distinct possibility of another deflation scare in the event of a shortfall in global growth. With core services inflation currently holding at its cycle low, there will be less of an offset to any cyclical downdraft in goods pricing. Consequently, a reversal of the recent upturn in commodity inflation could take the overall core CPI from its current rate of 2% back toward the 1% threshold that was almost tested in 2003. That is not idle conjecture. Given the distinct likelihood of a China slowdown — a risk that was not evident in 2003 — the odds of a downturn in the commodities piece of the core CPI are actually a good deal higher than was the case during the deflation scare of a couple of years ago. As long as the US remains on a path of secular disinflation — with lower highs and lower lows on the pricing front — there comes a point when the dynamic could go too far. That point could well be at hand. Depending on the depth and duration of any cyclical shortfall in global growth, I fear the next deflation scare could even be worse than the first one.
Financial markets are unprepared for another deflation scare. In the event of such a possibility, bond yields could fall sharply further. With today’s inflationary premium in the TIPS market (220 bp) fully 70 bp above the low hit in late 2002, another deflation scare could push yields on 10-year Treasuries through the 3.50% threshold. Earnings would also have increasingly scarce value in another deflation-risk scenario — enough to trigger another sharp sell-off in US equities. Moreover, in a low and falling interest rate climate, the dollar can be expected to come under renewed pressure as currency realignments play a more active role in the coming US current account adjustment. The trickiest aspect of this scenario is the deflation scare, itself. Two years ago, the core CPI slowed to just 1.2% in the six months ending February 2004 before rebounding quickly back toward 2% by the final quarter of the year. For reasons noted above, in the face of a China slowdown, downside risks to the core CPI hint at an outcome that might even go beyond the concept of just a deflation scare. The next time, it may be the real thing. So much for inflation phobia!