August 15, 2012 / 8:21 PM / 7 years ago

Deflation threat; small but global

(Reuters) - Further evidence of weak price rises globally shows that deflation is a growing, if small, threat.

U.S. consumer prices held steady in July, and are up just 1.4 percent in a year, while the core CPI, which strips out volatile food and energy prices, edged up just 0.1 percent in the month.

About a third of the items in the shopping basket that makes up the CPI fell in price in the month, up by more than half from earlier this year. While capacity utilization is now at an almost-normal 79 percent, the evidence today shows companies have little, if any, pricing power, a situation which, if it persists, may flag production cut-backs, not to mention profit warnings, in the future.

There are two interlocking drivers here. On a fundamental basis, as we’ve seen in Japan for more than a decade, an over-leveraged economy trying to become a less leveraged one is simply going to have sluggish economic growth and a tendency for weak price gains, if not outright deflation. More immediately, real weakness in Europe, and concern about the potential for extreme outcomes, is radiating outward.

Industry is contracting in much of Europe, with a striking fall in German factory orders, which are down almost 8.0 percent over a year. Despite a policy of capping Swiss franc strength against the euro, Switzerland is in outright deflation, with prices down 0.7 percent on a year ago. Japan too continues to see deflation, and like Switzerland is suffering from a strong yen.

Looking at China, growth there is cooling incredibly rapidly, with producer prices in a headlong fall and consumer inflation at just 1.8 percent on the latest reading, the lowest in 30 months. Export growth in July collapsed, falling to just 1.0 percent, from 11.0 percent the month before. Prices of exported goods fell by 0.5 percent. It should surprise no-one that the yuan is now a two-way risk, as likely, or even more likely, to fall as appreciate.

Though the sheer size of developed market indebtedness would likely mean sluggish growth anyway, it is important to understand the way in which uncertainty about the outcome in Europe is driving a preference for safety, driving up currencies that are relatively safe and driving down bond yields. This drive for safety is really just a wave of deflationary force coming out of Europe, one which will only reverse when investors become confident in a relatively benign outcome.

That might happen, but betting on it happening any time soon is probably foolish.


The market for Treasury Inflation-Protected Securities (TIPS), a type of U.S. bond with built in inflation insurance, is now discounting about a 15 percent risk of deflation over the coming five year period, according to a calculation by the Atlanta Federal Reserve. That’s up by half from earlier this year, but far below the levels the market was discounting in 2008 and 2009. That’s also a five year price, implying that the chances of a period of deflation within the next five years is higher.

Arguably the TIPS market has learned from Federal Reserve behavior and is telling you something different than it was in 2008. The series of extraordinary measures the Fed has taken have earned it deflation-fighting credibility, which is perhaps different from deflation prevention power.

Investors understand that the Fed will ultimately act, something they were perhaps less confident about in 2008, but they still place a reasonably high chance on the Fed being late. So we could have a drift into deflation, which the Fed would meet and defeat, but only after a certain amount of economic and market damage.

That is perhaps the best way to frame the argument, as being a choice between betting on fundamentals or betting on the authorities. The fundamentals are poor, and the results, given that we are now fully five years into the financial malaise, are dispiriting. Strength in financial assets, both bonds and stocks, is not reflecting, as historically it has, strength in the underlying economy, but rather faith in central bank action in fiat currency economies.

Clearly, fighting determined central banks makes no sense; they can always print money and shove prices in their preferred direction. We don’t, however, know that they actually are determined. The ECB is far from it, while the Fed seems scared of inflationary shadows.

Don’t expect any help from the fiscal side, at least outside of Asia. Europe will continue to pursue austerity, while very few U.S. election outcomes will lead to only a gentle scaling back of government spending.

Don’t be surprised by further evidence of falling prices as the year unfolds.

(At the time of publication 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. You can email him at and find more columns at

James Saft

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