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)

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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:

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Deflation Watch (May 2010): Headline Deflation Is Back!

April and May brought a renewed decline in the headline consumer price index, however it is not yet clear whether this trend is ready to stick. And curiously (and a little unexpectedly) rents seem to have stopped falling, at least for now.

Some Relevant Current Articles

• Have Residential Rents bottomed? - Calculated Risk says "There is some evidence that apartment rents have bottomed ... at least temporarily." And from the BLS: "The indexes for both rent and owners' equivalent rent were unchanged in May."

• Warren Mosler on oil prices (from March, but still relevant to the medium term trend):
  

"With supply following demand, as with any monopolistic arena, it looks like the world crude oil balance remains very much neutral leaving the Saudis in full control as swing producer where they set prices and let quantity adjust to market demand. Stable crude prices with 0 interest rates, high excess capacity and low aggregate demand should keep inflation at bay indefinitely, with productivity increases making deflation the greater risk."

Consumer Price Index Trends: Great Depression versus Today through May 2010 (US)

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I should note that this chart isn't intended to show we are following the Great Depression path, as we are clearly not (more details in the original deflation post), so perhaps a new chart is in order in the future.

However, it is looking like the headline CPI (red line) has been changing direction and may not make it back to the peak level from July 2008!

Annualized 3-Month Rate of Change for Components of US Consumer Price Index, Seasonally Adjusted (April 2006 - May 2010)

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The three month trend in CPI has gone negative for the first time since late 2008! However, transportation (dominated by energy prices) at -6.9% (annualized three month rate) and apparel at -3.6% (annualized three month rate) seem to be the primary drivers of the latest deflation. Housing (and its subset category, shelter) seem to have stopped declining, at least in recent months. The other components are all in positive (but sub 3%) inflation territory, with varying levels of volatility. Will we stay in negative price change territory? It seems likely the drag from energy prices will come to an end, so the answer is far from certain in the short term, though the overall dis-inflationary trend is nowhere near over.

Price Index Changes: Great Depression CPI versus Current PPI through January 2010 (US)

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Slowing in China, austerity in Europe, and the peaking of housing bubbles in countries such as Australia, Canada, and the UK could all contribute to a sustained end to rising commodity prices.

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:

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CPI in Japan (Jan 1980 - Jul 2009)

From previous posts, for reference: "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. A multi-year disinflation (of core CPI) leading to sustained mild deflation is one possible outcome for the US.

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Q1 Charts of Total Borrowing: Involuntary Deleveraging via Defaults, or Frugality?

I've been tracking the borrowing trends from the Z.1 Federal Reserve Flow of Funds report since last summer. Here is the Q1 2010 update:

Total US Government and Private Sector Borrowing Relative to GDP (Quarterly 2003 - 2010/Q1)

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The contraction in private sector borrowing (yellow line) appears to be in a declining trend. Total borrowing (combined private and public sectors) has gone marginally positive!

US Borrowing by Sector (Quarterly 2003 - 2010/Q1)

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The largest component of the private sector is the financial sector, and its contraction in borrowing (purple line) has been getting smaller, though at a slower rate. Notably, business borrowing (dark green line) was roughly flat in Q1 after contracting for four consecutive quarters. But home mortgage borrowing is contracting faster than before.

What best explains the private sector's negative borrowing rate? And why is the rate of decline getting smaller? In my last update I linked to some data that suggested "consumers haven't actually been paying down credit card debt since Q1 2009 — they've actually continued to add to debt, whether out of necessity or choice — so the overall contraction since then has been all due to charge-offs." Credit card debt is only one kind of borrowing, but it is likely correlated with consumer attitudes toward debt and therefore future trends in borrowing.

Edward Harrison, always a worthwhile read, is continuing to question whether consumers have really found frugality. In his latest post on the topic, he concludes: "Bottom line: people don’t change unless they are forced to do so. Americans are as spendthrift as ever. Wait until the economy hits a rough patch – and then we can talk about the demand for credit."

Many other commentators (myself included) have tended to assume that consumers are becoming more frugal after being burned by debt-driven asset bubbles and would both choose to incur less new debt and to pay down existing debt faster than before. This is the multi-year deleveraging process that so many expect. There is evidence to suggest this is occurring, but also conflicting evidence suggesting that defaults, not voluntary repayments, explain the primary trend. Understanding this dynamic is key to understanding likely economic outcomes and whether this is truly a non-temporary balance sheet recession as described by Richard Koo. Thoughts? Evidence I've missed?

New developments can of course change current attitudes and behaviors. Household wealth stands a good chance of declining again due to (a) a resumed decline in housing prices as the effects of the absolutely enormous government support for the housing market diminish somewhat, and (b) potential further drops in stock prices (more on that another time). Might lower asset prices (and especially directionally declining asset prices) lead to an increased frugality?

It would be tremendously useful in understanding macro trends to have government data like we have now in the Z1 and other reports, but disaggregated into various household wealth and income tiers. Such data could go a long way to distinguishing between trends driven by economic stress versus trends driven by choice. Unfortunately I don't know of any source of such data (and it would likely by necessity be collected from small sample sets, anyway).

Shadow and Flame

"Moria! Moria! Wonder of the Northern world! Too deep we delved there, and woke the nameless fear."
— Glóin from The Lord of the Rings 2 II The Council of Elrond

"The dwarves delved too greedily and too deep. You know what they awoke in the darkness of Khazad-dum... shadow and flame."
— Saruman

Apologies to non-Tolkien fans, but this example of life imitating art/literature struck me when I first read about the Deepwater Horizon explosion and oil spill. Tolkien powerfully captures the clash of nature and industry as one of the recurring themes in his Lord of the Rings trilogy, and tragically this disaster has some uncanny parallels. For those not familiar with the story of the Lord of the Rings, when the dwarves delve "too greedily and too deep" they awaken a Balrog, a demon of shadow and flame, and it proves too powerful to overcome. After much loss of life, the magnificent underground city and mining operation is abandoned.

Of course, the evidence is that this incident was avoidable, whether or not the driver was "greed" or a dysfunctional and reckless corporate culture (BP had an astonishing 760 egregious willful citations at refineries versus 1 for other companies in the same period!) . Yves Smith has provided solid coverage over recent weeks, and yesterday excerpted a letter sent from the government to BP: "In effect, it appears that BP repeatedly chose risky procedures in order to reduce costs and save time and made minimal efforts to contain the added risk." (much more via the link).

A guest post by George Washington and a link highlighted by Yves Smith both get into the possibility of undisclosed damage to the system and the threat of an accelerated flow of oil with no credible way to contain it at the well site. A knowledgeable commenter on Yves' site concludes "the relief well has to work. They will have to keep trying until they intersect the well."

If you need a less alarmist perspective, think of the oil spill relative to the Gulf of Mexico as "ONE raindrop in 10 olympic sized swimming pools" (and better mandate all wildlife to cease swimming or landing in the vicinity of said raindrop until further notice!) I suppose this is a bit sarcastic but I actually find it a worthwhile data point as food for thought, despite believing it to be rather misleading.

What To Expect From This Blog

I realize I haven't posted in a couple months, so I thought that a short status post might be valuable. The brief summary is that you are likely to see continued sporadic posts here in the future, though probably less often than before (not that they were ever frequent!) I'm less likely to do updates every month/quarter of certain series of posts I've been covering, though I will make an effort to update them when the data changes in a noteworthy way. For example, the deflationary CPI trend is now becoming apparent to more and more observers and bears revisiting. Remember, Japan's deflation took years to arrive after its asset bubbles peaked. Other past topics likely to be revisited include Modern Monetary Theory, flow of funds data and borrowing trends, macroeconomic and market outlook, stock dividend trends, deflation outside the US, etc. New topics won't be frequent but I do have some some in mind.

I didn't exactly plan to have an economics blog (I'm an engineer, for one thing). I initially set it up as an easy platform to share my macroeconomic and market outlook, distilled from much reading in the econoblogosphere, with a select set of real life acquaintances. However, I subsequently found myself becoming dissatisfied with some gaps in my knowledge and with some of the third party commentary I'd been reading, so I decided to do more digging in raw data myself, wherever possible, rather than only relying on the commentary and analysis of others. And at times the data has seemed worth sharing. I hope some have found it useful — this site has 60+ RSS subscribers via Google Reader (and I don't know how many in other readers) — a small number, especially given that many probably don't read all their feeds, but not zero!

Other than general time constraints, the other reason for the shortage of posts lately is I've been putting a little time into attempting a second macroeconomic visualization that I hope could have broader value, if successful, than the last one (which I know still needs further updates). So if I make progress on it, look for a future post introducing it.

As a bonus for reading this far, and so as to include some actual economic content, here is a chart from an April presentation by Richard Koo that I think is useful and have not seen posted elsewhere:

It's the first actual "picture" of the so-called reverse-square-root-sign recovery that I recall seeing, and nicely shows two things. First, that the "Lehman Shock" probably did contribute to a collapse in confidence and GDP beyond that attributable to the Minsky-style private debt dynamics alone (though contagion and adverse feedback loops were certainly a real risk that could have kept GDP on its downward path, even so). Japan's GDP never fell this dramatically, even after its own giant asset bubbles popped. Second, it shows the uncertain future with respect to the degree of ongoing private sector deleveraging versus government fiscal stimulus.

Total Borrowing Still Contracting at a Stable Rate in Q4 2009 ($577 billion annualized)

The Z.1 Federal Reserve Flow of Funds report is out for Q4 2009. Here are some updated graphs:

Total US Government and Private Sector Borrowing Relative to GDP (Quarterly 2003 - 2009/Q4)

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US Borrowing by Sector (Quarterly 2003 - 2009/Q4)

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The trend has been somewhat consistent over the last three quarters, with the size of government borrowing almost offsetting the contraction in private sector borrowing, which has been largest (as a percentage of GDP) in the financial sector. However, it seems the financial sector's rate of negative borrowing is shrinking, a trend which bears watching. Home mortgages, consumer credit, and business debt all show continued contraction, but there is no way to know which way their trends will go from here. A lot may depend on the future path of housing prices, which most likely aren't completely done falling. But it's possible there could be some surprises, for example Felix Salmon observes (and EconomPic charts) that consumers haven't actually been paying down credit card debt since Q1 2009 — they've actually continued to add to debt, whether out of necessity or choice — so the overall contraction since then has been all due to charge-offs.

In rough terms, I think these graphs show:

1. Fears of "massive" government debt supply driving up interest rates to any dangerous degree are misplaced. Government bonds (plus shorter duration instruments) are replacing disappearing private sector assets. (See further discussion of outlook for treasuries here).
   
2. Government deficit spending (a lot of it via the automatic stabilizers) has helped sustain incomes in the face of defaults and attempted private sector deleveraging, thus preventing a worse outcome to date. Of course, there is a lot that can still go wrong.
   

Some past posts discuss these graphs in more detail:

• Deadlock! Total Borrowing Has Stabilized at a Mild Contraction Rate as Private Debt Reduction Stops Increasing and Government Borrowing Stays Steady
• Total Borrowing Continues Contracting in Q2
• Why Treasuries Find Buyers and Interest Rates Will Not Rise (Much)

Balance Sheet Wealth in the US and Japan; Historical Data in the Context of Modern Monetary Theory

While gradually learning more about Modern Monetary Theory (aka Chartalism) I've started looking at the balance sheet tables in the official national accounts data of the US and Japan. MMT emphasizes stock-flow consistent modeling of the economy when analyzing the impact of various private sector and government actions. Separately, I've started creating a macroeconomic balance sheet visualization tool to illustrate this approach. But in this post I'll share some charts of the real world "stock" data (i.e., accumulated aggregate wealth). I'll likely share some related "flow" data (i.e., components of Gross Domestic Product as a measure of national income) in a subsequent post.

One of the principles of MMT is that the non-government sector (which includes the domestic private sector as well as the foreign sector) cannot change its own net financial assets. Only the government can, by running a deficit or a surplus. One of the key roles of a government deficit is to allow the private sector as a whole to net save (i.e., spend less than it earns). This results in an accumulation within the non-government sector of "wealth" (also referred to as balance sheet equity or net worth) in the form of government liabilities, which are a mix of treasury bonds (and notes and bills), physical currency (notes and coins), and bank deposits (matched by corresponding bank reserves). These are all just liabilities of the government with different durations and interest rates, and they never have to be paid back (though with a healthy growing economy they often shrink as a percentage of GDP). The emphasis that government liabilities are also assets is one of the most important insights of MMT, in my opinion. The primary limitation to running government deficits is inflation.

These aggregate "stocks" are illustrated in this simplified balance sheet diagram that excludes tangible assets — the government sector (combined treasury and central bank) has (as an indisputable accounting identity) negative financial net worth (i.e., when you exclude tangible assets like buildings and equipment) exactly equal to the positive financial net worth of the private sector. In this case $160 (just toy numbers for illustration) — the blue boxes labeled "equity" and "negative equity". Balance sheet equity or net worth equals assets minus liabilities. Note, this graphic leaves out the foreign sector for simplicity.

However, there are a few areas I still find myself disagreeing with MMT on (subject to change as I learn more!) and one is the treatment of equities/shares (in the stock market sense). In short, when the market bids up stock prices, owners of those stocks feel wealthier, but the corporations to which those shares are a liability do not act correspondingly poorer or reduce their propensity to invest or generate revenue in any way. I could elaborate but will leave it at that for now as that is not the focus of this post.

The charts of wealth below combine:

• Tangible assets (real estate, equipment, software, etc).
• Net government liabilities (since these are assets to the private sector and typically never have to be paid back on aggregate).
• Total valuation of publicly traded stock market (market prices of bonds and other securities may also have impacts on net perceived wealth but I have skipped those for now). [Note: Admittedly if we are only looking at net financial assets (assets minus liabilities) then perhaps we should subtract from this the total "paid in capital" liability entries across all corporate balance sheets, but aside from that data not being available in this source, from a behavioral standpoint I don't think those liabilities impact economic activity in the same way that debt liabilities do, so I'm not convinced they should be subtracted anyway.]
  

There are two totals in each graph, one including stock market valuation and one without, because as mentioned above the appropriate treatment of this seems debatable to me. You the reader can choose which total you prefer.

I don't know how directly comparable the Japanese and US data are. It is possible that the underlying accounting (for example what is included in tangible assets, how values are determined, etc) could differ substantially. But in a broad trend sense the comparisons are still interesting. One significant difference I know of is that the tangible assets data for the US only includes households, corporate non-financial business, and non-corporate business, whereas the Japanese tangible assets data includes all sectors (government and financial corporate being two large sectors that are not in the US data).

Balance Sheet Wealth in Japan (1980-2007)

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Observations:

• Japan's stock market peaked (on an annual basis) in 1989 (yellow line). Its real estate bubble peaked in 1990 (red line, to which real estate and land are the largest contributors).
• Aggregate balance sheet valuation of tangible assets declined from 1990 until 2004. While this is probably due primarily to declining market prices (revaluation and/or depreciation), it's possible that quantity also changed.
• Government deficits have clearly helped stabilize nominal private sector wealth relative to what would have occurred otherwise (see the dark blue and light blue lines for totals with and without stock prices).
• Government liabilities are not particularly large as a percentage of total wealth. Of course the annual deficits that created the net liabilities would have contributed significantly to incomes, and that effect is not shown here.
  

Balance Sheet Wealth in United States (1980-2009/Q3)

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Observations:

• NOTE: US tangible assets shown here does not include all sectors (see note above).
• The US had two stock market peaks (note that this is the entire public share market as captured in Flow of Funds data, not a particular index such as S&P500), first in 1999 (on an end of year basis), and second in 2007 (see yellow line).
• Tangible asset prices (red line, dominated by real estate) peaked in 2006 (on an end of year basis).
  

Balance Sheet Wealth in Japan (1980-2007) as Percent of GDP

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Observations:

• Wealth relative to nominal GDP adjusts in rough terms for changes in price level (inflation), demographics, and productivity.
  
• Because Japan's GDP has partially stagnated, wealth relative to GDP does not look dramatically different to wealth in nominal terms (prior graph).

Balance Sheet Wealth in United States (1980-2009/Q3) as Percent of GDP

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Observations:

• NOTE: US tangible assets shown here does not include all sectors (see note above).
• Wealth relative to GDP has slowed its fall and is in the rough vicinity of the level from before stock market and housing bubbles accelerated in the mid 1990s.
  
• I don't know whether wealth-to-GDP is mean-reverting or even meaningful over long periods of time, but if it is, perhaps this reversion is a positive sign of stabilization suggesting nominal wealth need not fall much further. Though given the likelihood of further falls in residential and commercial real estate prices (the opinion of many credible commentators), a not-so-positive alternative is that both nominal wealth and GDP could fall at the same time, still leaving their ratio semi-stable.
• Interestingly the Japanese and US stock markets both peaked at just over 200% of GDP! (Some have called the Japanese stock bubble larger, but perhaps it just rose more quickly from more undervalued levels). Yet at the end of 2007 (the latest Japanese data), Japan's stock market valuation was at 108% of GDP, and the US at 182% of GDP, and Japan's market has had the bigger fall since 2007. This suggests some potential combination of (please comment if you have insights!):
• Japanese stocks undervalued.
• US stocks overvalued.
• Japanese public companies inherently less profitable.
• Japan's market pricing in lower growth prospects.
• Japan's publicly traded companies commanding a smaller share of the economy (relative to private enterprise) than US publicly traded companies.
• US stocks still look overpriced relative to GDP, though a longer time line is needed to confirm this, and a valid justification for the higher level could be if public companies control a larger share of economic activity than in the past.
  

Year-on-Year Change in Balance Sheet Wealth in Japan (1980-2007)

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Observations:

• The year on year change makes it easier to see the magnitude of the changes in the previous graphs.

Year-on-Year Change in Balance Sheet Wealth in United States (1980-2009/Q3)

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Observations:

• From a wealth perspective alone, increases in US government debt (green line) have been small relative to tangible asset and stock market losses, however from an income perspective (money that actually contributes to GDP), it is very clear that government deficits have prevented (so far) a far worse outcome. (I'll include flow/income charts in a separate post).