Thursday, August 19, 2010

Deflation Watch (July 2010): Still Disinflating Japanese Style, Actual CPI Deflation Probably Not Imminent

Three months of negative month-on-month CPI prints (a trend which broke in July) have generated an absolutely astounding amount of deflation commentary in the econoblogosphere! The Japanese-style-deflation-in-the-US meme has certainly reached critical mass in at least some circles...

I decided this month to finally update my charts. The format carried over from my original post comparing historical deflationary episodes overdoes the Great Depression comparison, despite being useful at the time (a year ago, negative year-on-year CPI reports had prompted a renewed surge in deflation chatter).

Some Relevant Current Articles

My list of relevant links has grown long, and in the interest of actually publishing a chart update today with the latest data, I'll save the links for a later post. (Some others are even labeling their posts "deflation watch" as well!)

Post-Bubble Consumer Price Index Trends: Current US (post-2007) versus Japan (post-1989) versus the US Great Depression (post-1929)
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The above chart shows the actual price levels for the three commonly discussed post-asset-bubble deflationary episodes. Here are the year-on-year inflation rates for the same time periods:

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Rather than attempting to align all three episodes of data at a CPI peak, they are instead now aligned at the dates that wealth (i.e., asset values such as real estate and equities) peaked. The goal is to compare the effects of the post-asset-bubble deflationary forces on the actual consumer price level trend in each case. I considered a few other possible alignment points, such as the peak in private sector borrowing (as debt-fueled asset bubbles tend to be the largest). However the peak private sector rate of debt-growth before the Great Depression was actually in 1925 (!), and overall the peak in balance sheet wealth seemed the most logical choice. The main reason for this choice is that falling asset values (along with a post-bubble consumer mentality) typically induce a higher attempted private sector savings rate, which will typically cause an aggregate demand deficiency and lead to downward pressures on prices and wages. Some charts of balance sheet wealth in the US and post-bubble Japan are in this previous post. The rough peaks I used (these are not terribly precise) for the charts were November 1929 for the Great Depression, mid 1989 for Japan, and mid 2007 for the US.

Key Observation: The US price level is currently following a similar path to Japan's experience (though slightly more rapid than Japan, still very far from the Great Depression experience), and it took many years of disinflation before Japan experienced sustained (mild) deflation. That said, the downside economic risks are much larger in the US today than in Japan post-1989. A number of factors still threaten a faster move through disinflation to deflation for the US today, including but not limited to:
  • Higher unemployment in the US today than 1990s Japan
  • Risk of negative global demand shocks due to such factors as deflating global housing bubbles (real estate prices in many countries are still nearer peak than trough by price/earnings and price/income measures).
  • Anti-deficit political pressure that threatens reductions in US fiscal policy spending
  • A low likelihood of any non-government sector (household or business) driving growth by reducing its savings rate significantly (Japan's consumers provided just this boost to demand by reducing their savings rate from around 15% in 1990 to under 5% by the early 2000s)
Still, it's probably premature to expect US deflation in the immediate months ahead.

Trends in Consumer and Producer Price Index Levels (CPI & PPI, Seasonally Adjusted)

(click on chart for a larger version in a new window)

The chart above shows various CPI and PPI measures, aligned at 100% on July 2008 when the CPI peaked. It is intended to help in comparing the trends in absolute price levels (not rate of change). For example, crude materials (PPI) and energy (CPI) are clearly more volatile than finished goods (PPI) or headline or core CPI, but you can see at times (especially late 2008) how they can drag the other indexes around.

Annualized 3-Month Rate of Change for Components of US Consumer Price Index, Seasonally Adjusted
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This chart shows the short term (three month) rate of change of the components of CPI, to help identify underlying inflationary and deflationary forces within the overall CPI basket. Many components are quite volatile despite being seasonally adjusted.

A surprising number of components (food, housing, recreation, and overall headline) are showing a flat (0%) three month rate of change. But shelter (a subset of housing I have separated due to its importance) has broken its deflationary trend and continues with positive inflation! I am still looking for a good explanation (Calculated Risk has commented a little but is also unsure of details). If this continues, it removes a lot of the near-term deflationary impulse on the overall index, and perhaps actual lasting CPI deflation is still years away like Japan's was (or perhaps even not at all).

16% Trimmed CPI

The 16% trimmed mean CPI (generated from the Cleveland Fed site) removes the most extreme monthly price changes, and is still falling after only a brief interruption in the trend:

(click on chart for a larger version in a new window)

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