Albert Edwards: "A Full Blown Deflationary Episode" Coming
"With import prices down some 19% yoy and even a record 7.3% yoy if one excludes petroleum, no wonder the price of domestic purchases has already fallen into deflation. If anything, domestic purchases inflation leads trends in both GDP and core CPI, so this is significant news."Incidentally, Edwards also offers some confirmation of my expectation that banks will increasingly buy treasuries:
"But what about massive supply of government bonds I hear you ask? Won't that drive yields higher? Well it never did in Japan. But let's cast our minds back to the early 1990's US credit crunch (which seems so minor in retrospect!). What happened then is that US commercial banks bought US Treasuries aggressively at the same time as they contracted lending to the private sector (see chart below). This continued well after the end of recession in early 1991."David Rosenberg has been outlining some similar deflation themes in recent newsletters as well.
Chris Whalen of Institutional Risk Analytics gets colorful in his latest newsletter, Q2 2009 Bank Stress Test Results: The Zombie Dance Party Rocks On:
"Despite all of the talk and expenditure in Washington, the US banking industry is still sinking steadily and neither the Obama Administration nor the Federal Reserve seem to have any more bullets to fire at the deflation monster."So what exactly does this deflation threat look like and how does it compare to historical episodes of deflation? I decided to take a closer look at some of the data myself, and I'll share some charts below.
First, a clarification of what is meant by "deflation". While most people think of it as a reduction in [consumer] prices, others, for example Austrian economists, define it as a "contraction of money and credit", and this is a valuable viewpoint in part because broad money supply changes often precede changes in consumer prices. Both total private sector borrowing (see chart here) and bank credit (see chart here) have been contracting so far in 2009. Then there is of course asset price deflation, and there is no question this has been significant since the crisis began, for both real estate and stock market prices, and that this is one driver of reducing spending. This post focuses on consumer price inflation/deflation, even though the other measures are probably more important in general to understanding the macroeconomic trend.
To visualize Consumer Price Inflation, I've only seen graphs of period-based changes in the price level (month-on-month or year-on-year), such as this chart from the July 2009 BLS CPI report:
This is sufficient in normal times during which price levels only move in one direction (up). But with some price measures (especially energy) recently bouncing between positive and negative directional changes, I think the period-based change charts can be too volatile to use alone, since they don't show the big picture of where prices were in the prior period, despite being an excellent tool for focusing in on rate of change. Since I couldn't find any graphs of price levels (as opposed to change in price level), even though they must be out there, I made my own. Here is the first showing consumer price index trends in the US today compared to the Great Depression:
The place where all the lines meet on the chart (at 31 months) is normalized to 100% with all price levels relative to that peak. This point corresponds to July 2008 for the modern data and November 1929 for the Great Depression data. I have chosen to show several years preceding this point to give context to how quickly each measure had risen before peaking. Some observations:
- CPI has been measured with different methodologies at different times, so this is not an apples-to-apples comparison.
- After peaking in July 2008, headline CPI plunged at a faster rate than the onset of the Great Depression. No wonder (among other reasons) treasuries rallied so dramatically at the end of 2008 and then reversed as headline CPI started heading higher again!
- Core CPI (excluding food and energy prices) has kept rising, but the pace of increase is slowing in 2009, even with energy prices relatively stabilized, despite coinciding with the largest monetary and fiscal stimulus in history! Is the battle with the "deflation monster" being slowly lost?
- Looking at the BLS year-on-year CPI chart further above, the trough in the rate of change of core CPI of around 1% in early 2004 was almost four years after the dot-com stock market bubble popped, and over two years after the recession lasting officially from March 2001 to November 2001 ended! So (at the risk of being wrong by using only one data point) impacts to core CPI seem to lag recessions and changes in asset prices by years. It seems likely that this trend will replay today.
- Headline CPI has turned (mildly) negative again in July — will a full downward trend resume? Might we face price deflation as ferocious as in the Great Depression? Personally I think it unlikely, but can't rule it out entirely.
- I added energy prices to the graph because they have been so volatile (whether due to global demand exceeding supplies, rampant financial speculation in energy as an asset class, or some combination of both). One way of looking at the effect on headline CPI is that the violent energy price spike simply forced headline CPI higher between mid 2007 and mid 2008 and that this is the primary cause of current deflation. While partially valid, I don't think that's the whole story.
I was unable to find information on the relative weighting of the CPI components from this era. My observations:
- Leading up the the minor peak of CPI in November 1929, all price measures except food were already in a couple years of moderate deflation. Could that have made them susceptible to rapidly tipping into a self-reinforcing adverse feedback loop of severe deflation when the economy was hit by the deflationary shock of contracting credit and falling asset prices?
- As prices declined, food fell the most dramatically (almost down to half its peak price), dragging down the overall CPI. Is this analogous to commodity prices today? It's my guess (without any specific knowledge) that food prices back then tracked more closely to pure agricultural commodities, if there was less processed food, restaurant food, etc available.
- Electricity prices did not deviate from their mild downward trajectory until overall CPI bottomed after several years — perhaps they were effected by regulation, high labor costs, or some other factor?
The thicker lines represent heavier weights within the overall index. Observations:
- Most of the components with smaller weights (medical care, recreation, education and communication, other goods and services) have still been trending higher.
- Apparel has been remarkably flat for years (recently trending up) — I would have guessed we'd see more deflation in these prices.
- Housing is the largest category (weighted 43% of CPI) and it appears to be in a gradually accelerating downward trend. I (and others) expect this to intensify in the years ahead, thus dragging down overall CPI due to the heavy weight. Rents and owners' equivalent rents are heavily weighted, and they are starting to decline in the real world due to the huge excess supply of housing built over recent years with more and more being added to the rental market, as well as recession-specific factors such as more people sharing housing or apartments to save money rather than living alone. I have read that this CPI component lags real world changes in rent.
- Food is the second largest category (weighted 16% of CPI) and it also appears to have started a mild downward trend. If this continues, it will also pressure the overall CPI downward.
- Transportation is the third largest category (weighted 15% of CPI) and it already fell precipitously and has been gradually rebounding. maintaining upward pressure on CPI. Will it keep rising, level out, or start falling again? Any change from the current upward direction could have an out-sized impact on CPI, given that this has been the largest weighted component in a rising trend in 2009.
Though it may be even less of an apples-to-apples comparison than comparing CPI from two eras, I decided to compare PPI (Producer Price Index) today to CPI during the Great Depression (PPI data is not available from then):
- Producer prices have fallen at a far more rapid pace since peaking in July 2008 than consumer prices during the onset of the Great Depression. They have stabilized but not resumed a convincing uptrend.
- With such a dramatic divergence between crude, intermediate, and finished goods measures, clearly the enormous upward spike in crude goods prices prior to July 2008 has made it easier for there to be a rapid decline following the peak, so it may not be worth putting much weight on this graph, except as food for thought.
- However, some observers suggest that PPI is a predictor of future CPI.
- While I won't go so far as to predict it, it would not surprise me if the China growth story (which has numerous skeptics with convincing arguments) falters within the next year or two, leading to a fresh crash in commodity prices. Could this tip PPI and later CPI into a downward spiral?
I used January 1990 (the peak of Japan's stock market bubble) as the anchoring point for Japan's data because there was no CPI peak at the start of their 1990s "balance sheet recession" (note I made a mistake graphing and the Japan data is shifted 6 months to the right in the chart from the anchor point.). I am surprised at how long it took the inflation rate to decline — it took 3-4 years for price levels to begin to flatten out. Even into the late 1990s, there was still no real price deflation, despite a huge deflation in asset prices. Japan's real estate prices peaked around 1991 (according to Richard Koo's presentation graphs) so perhaps the delay between peaking asset bubbles contributed to sustaining inflation. Nevertheless, there was disinflation (falling positive inflation), so in hindsight I should have aligned the different series for all these graphs via the peak year-over-year CPI rate of change rather than the peak price level itself.
The peak of Japan's CPI occurred in October 1998, almost eight years after the stock market peaked, and Japan's notorious mild deflation has been in effect since then:
Is the Great Depression experience or the Japanese experience more relevant for the US and the world today? I don't know the answer, but I would guess price inflation/deflation dynamics will be closer on the spectrum to the Japanese experience than to the Great Depression, though I think the dramatic price decline scenario could occur. With practically the entire world simultaneously awash in excess capacity and experiencing debt deflation (contraction of debt levels due to private sector deleveraging), the underlying conditions are certainly closer to those of the Great Depression, which was the last global debt crisis. But will developing countries such as China achieve sustainable growth in the next few years and provide a backdrop of growth much like that which surrounded Japan post-1990? On China at least I am skeptical.
The key question, to which most observers believe the answer is yes, is will structural differences in modern economies (versus the 1930s) or differences in government responses be able to avert severe broad price deflation this time? I sincerely hope the majority is correct for a change.
UPDATE 9/7/2009: A commenter pointed out that it may be too early to tell the effect of stimulus on core CPI, which is true. The data I've shown is not conclusive with respect to any future outcome. However, in the context of contracting private debt and the trends I've discussed before I'm predisposed to expect the types of outcomes described by the likes of Steve Keen (who builds on the work of Hyman Minsky among others) and Richard Koo (author of the phrase "Balance Sheet Recession").