Risks of deflation rising again: James Saft

Thu Jul 5, 2012 12:24am EDT

Related Topics

(Reuters) - The Federal Reserve can and will fight the threat of falling prices.

What is a lot less clear is whether the extraordinary monetary policy we may soon be seeing will be effective in staving off another recession.

The recent run of data on prices has shown a clearly falling trend, doubtless driven by a recession in Europe and a marked slowing in China's economy.

U.S. manufacturing contracted in May, according to a survey from The Institute for Supply Management. Even more striking: the index of prices paid decreased to 37 from 47.5, with 50 denoting the line between rising and falling prices. That is nothing less than a lurch towards deflation.

The consumer price index fell by 0.3 percent in May on a seasonally adjusted basis, the first such fall in two years and the worst since December 2008, at the height of the financial crisis.

Manufacturing readings out of Europe and Asia have also had a gloomy tone, and commodity prices are down by about 10 percent since the beginning of March.

What's more, despite the fog that surrounds Chinese economic measurement, there are strong signs of slowing there and that credit-fueled appetite for resources and property has reversed.

In the 67 years for which we have data, the U.S. economy has slipped into recession 75 percent of the time the ISM fell this badly in nominal terms, according to economist David Rosenberg of Gluskin, Sheff in Toronto.

"We haven't seen something like this since April 2009 and the difference back then is the recession was coming to an end. This time it is the expansion that is looking fatigued and policymakers are running out of responses," he wrote in a note to clients.

This is exactly the point: The Fed's Herculean efforts have been effective in staving off deflation, if only temporarily, but far less good at fomenting actual sustainable growth.

As the now Fed chief Ben Bernanke laid out in his famous "helicopter" speech in 2002, a central bank possessed of a printing press can always fight deflation by, if need be, raining down money from the skies.

But fighting and winning are two different things, especially when a central bank is having to fight the battle without aid from fiscal authorities, as is likely to be the case in the U.S.

If current tax and spending plans aren't amended the deficit would be shrunk by about 4 percent of GDP next year, something the International Monetary Fund believes would slash U.S. growth to well below 1 percent, with contraction early next year.


Despite virtually zero interest rates, despite QE1 and 2 and Operation Twist, and even despite a rush to supposedly safe Treasuries which have driven financing rates lower without help from the Fed, still we have an economy which fails to thrive.

The Fed can introduce all of the liquidity into the economy it likes, but it cannot force banks to lend or people to borrow. The central bank has tripled the monetary base since 2008, but the speed at which money circulates through the economy has slowed, a sure sign that higher doses of the same medicine won't be fully effective.

"We think that the global forces behind deleveraging have more firepower than all of the world's central banks and governments together, and that deflation is a much more likely outcome than a major inflation," fund managers Comstock Partners wrote in a June note to clients.

That's because debt is being repaid and destroyed rather than created, as companies, individuals and states try to cut risk. Household debt levels in the U.S. have fallen for a remarkable 16 straight quarters, and still have far to go to reach historic norms. In addition the shadow banking system's assets continue to contract.

Even if politics allowed for stimulus, which it probably won't, the Fed would have a difficult time using the tools it has to reverse this process.

None of this is to say that the Fed and other central banks won't try, especially as the weeks go by and the negative data points collect. That could well drive financial markets higher. The response among investors is still to trust in a rescue from on high.

The disconnect between financial markets and the economy cannot last forever, a reality that may even be dawning among policymakers.

In the meantime, look for the words "deflation" and "recession" to pop up with increasing regularity, and with them, expectations for one more round of extraordinary monetary policy.

(Editing by James Dalgleish)

(At the time of publication, Reuters columnist James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click on SAFT)

(James Saft is a Reuters columnist. The opinions expressed are his own)

We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/
Comments (4)
whyknot wrote:
Time to take your antidepressing medicine ?

Jul 05, 2012 9:56am EDT  --  Report as abuse
Ananke wrote:
My rent increased 25% this year; my health insurance premiums increased 25% this year. I am not even going to comment on the gas price alone. All of these because of the FED loose money policy pumping cheap money in the capital markets only…but these non-CPI components are consuming ALL my disposable income. In essence, I can consume goods/services only if they are provided free. The only reason that deflation is not skyrocketing is because there are people who are taking loans to buy goods/services, and these people believe they can repay the loans, when clearly they haven’t been able to repay any loan in the past…
So, FED is creating deflationary Keynesian thrift paradox when providing QE to the markets. Also, FED cannot do anything better – the problem is structural since wealth is distributed progressively to the top earners. I don’t believe the Congress will implement anything either, in order to redistribute income and boost consumption, so we are waiting until social change occurs driven from outside factors – probably Arab Spring kind.

Jul 05, 2012 3:19pm EDT  --  Report as abuse
Neurochuck wrote:
China’s 5yr plan is said to be about growing the economy by increasing wages, creating better social security to encourage spending rather than saving of wages, and building infrastructure to increase employment, and consequently grow the tax base.
USA’s “plan” seems to be to deflate wages, force people to save and avoid debt in case of unemployment or health problems, and unemploy as many as possible, in the private and non-private sectors.
So “communist” China is doing capitalism (probably successfully and with broad popular support) and “capitalist” America is doing feudal usurism and debt slavery (and risking economic and social disintegration).
I don’t understand. Why is this so ?

Jul 05, 2012 6:41pm EDT  --  Report as abuse
This discussion is now closed. We welcome comments on our articles for a limited period after their publication.