Clarifying the debate about deflation concerns

Mickey Levy, 21 February 2014

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A common theme among many economic policymakers, financial market participants, and the media is that rich industrialised nations face a high risk of deflation, and that deflation always harms economic performance and so must be combatted with aggressive macroeconomic stimulus. Such broad assessments are misleading, and under certain circumstances may lead to misguided policies. More clarity on the topic is required.

Year-over-year inflation measures in the US, Europe, and Japan have converged close to 1% – the US and the Eurozone have experienced disinflation, while in Japan modest inflation has replaced four years of mild deflation. However, the conditions influencing their respective outlooks vary widely.

Figure 1. Inflation in the US, the Eurozone, and Japan

Observations and comparisons

There is far too much angst about the possibility of deflation in the US. With nominal GDP accelerating, labour markets improving, and the cost of housing shelter (owners’ occupied rent) accelerating, the probability of deflation is near zero. It is highly probable – perhaps 80% to 90% – that core inflation has troughed, and will rise modestly in 2014–2015. Moreover, far too little attention has been paid to the fact that the vast majority of the US’s recent disinflation has resulted from technological innovations that raise economic performance and potential. This is very different from disinflation/deflation associated with insufficient aggregate demand, which may adversely affect spending behaviour and exacerbate economic underperformance.

In contrast, Europe suffers from sluggish economic growth and ongoing adjustments following a sustained period of excesses. The most likely outcome is that inflation will stay very low and likely recede toward zero, and there is some nontrivial probability – perhaps 20% – of temporary mild deflation. The proper balance of policies must weigh the need for economic reforms and long-run objectives with near-term concerns about deflation.

Japan faces a very different situation. Its two-decade-long struggle with on-and-off deflation and economic malaise illustrates the harmful effects of misguided policies that result in insufficient demand and constrain economic activity. The Abe administration is attempting to radically change expectations and boost performance. Success hinges on whether the Bank of Japan’s aggressive monetary stimulus boosts confidence sufficiently to generate sustained increases in spending, and whether the stimulus is accompanied by reforms that tackle economic inefficiencies and lift potential growth. Thus far, longer-run reforms are lacking. I expect that in 2014 core inflation will stay above 1%, but below the Abe administration’s 2% goal.

Aggregate demand and productive capacity

In the US, the year-over-year core Personal Consumption Expenditures (PCE) index is at 1.2%, and the core CPI is at 1.7% – down from 1.8% and 1.9%, respectively, in the previous year. This disinflation is a lagged consequence of the disappointingly modest growth in aggregate demand that has constrained business pricing power, and high unemployment that has dampened wages, along with lower prices of selected goods and services benefitting from technological innovations.

However, nominal GDP – the broadest measure of aggregate demand – has grown comfortably faster than estimated real potential throughout the soft economic recovery. In the second half of 2013 it grew at an annualised rate of above 5% – a significant acceleration from the previous year’s 3.1%. Such growth in aggregate demand far in excess of productive capacity virtually rules out deflation. If growth remains healthy, which seems likely, fuelled by monetary stimulus and a continued diminution of economic headwinds, the stronger economic activity and associated improvement in labour markets would influence price- and wage-setting behaviour, and begin to generate inflation and wage pressures.

Figure 2. Nominal GDP growth in the US and the Eurozone

 

 

 

 

 

Adjustment in Europe

Europe’s recovery from financial crisis and its many necessary adjustments are at a much earlier stage. Weak aggregate demand puts downward pressure on product pricing. Nominal GDP in the Eurozone rose 0.7% in 2012 and an estimated 1% in 2013 – below estimates of potential growth. High unemployment and slack labour markets are expected to persist, and still lower wages are needed in troubled nations to regain competitiveness. To date, the stickiness of wages – which continue to rise in real terms in France and Italy – highlights the slow adjustments to the new economic realities. Despite some positive reforms, an array of regulatory, economic, and fiscal policies continue to constrain productive capacity, and many reforms and austerity measures have been put on hold. Europe’s risks of deflation are nontrivial.

In the last year, virtually every EU nation experienced downward price pressures, but inflation varies around the Eurozone’s harmonised rate of 0.9%. With the exception of Greece – which has deflation of 1.8% – inflation has been modest in all European nations, ranging from Spain’s 0.3% to Germany’s 1.2%.

Europe’s road to healthy economic performance will be difficult, and policymakers face tough choices and tradeoffs. Should the ECB move aggressively with a US- or Japanese-style round of quantitative easing in an attempt to avert deflation? No. The challenges facing Europe are real and not monetary, and the ECB’s monetary policy is already accommodative, with a negative real policy rate and ample liquidity in the financial system. Unintended consequences of aggressive QE may be costly. Such an ECB shift may signal to Europe’s fiscal and economic policymakers that they may postpone necessary reforms. Or it may influence private-sector wage negotiations and result in delays in real wage adjustments. While lowering its policy rate or countering banks’ repayment of long-term refinancing operations by otherwise signalling that it will maintain sufficient liquidity seems appropriate, avoiding QE and its potential unintended policy side effects would be best for Europe’s long-run potential. That is, a brush with price stability or even temporary deflation along the road to recovery may be the best – albeit painful – path of adjustment from earlier excesses.

Japan’s malaise

Japan’s challenges are very different. Its nominal GDP is barely above where it was in 1991. It rose through 1997, was flat through 2007, plummeted in 2008–2009 and currently remains nearly 7% below its prior expansion peak. This prolonged underperformance has resulted from a combination of insufficient aggregate demand (misguided monetary and banking policies), a wide array of growth-suppressing regulatory and economic policies, and a declining population and workforce. Real GDP has grown only as a consequence of a persistent decline in the deflator, with intermittent periods of deflation and recession. This sustained malaise dampened expectations, and constrained households’ and businesses’ propensity to spend.

Figure 3. Japan’s malaise

Japan is trying to escape this environment. Early responses to the Bank of Japan’s aggressive QE and lower yen have been positive – confidence has jumped, real growth has accelerated above potential, and inflation has increased to 1.1% year-over-year. But it’s far too early to claim success. Critics are correct that failure to implement economic, regulatory, and immigration reforms constrain long-run potential growth and drain confidence. But for 2014, sustained efforts to boost confidence – which in all likelihood requires a weaker yen, a stronger Nikkei, and rising wages – are likely to support core inflation (excluding the one-time impact of the consumption tax hike) between 1% and 2% and above-potential growth, despite the drag from the scheduled tax hike.

The Abe administration’s goal of achieving 2% inflation is only an intermediate target. Along with monetary stimulus, expectations of rising prices (and higher wages) are hoped to support stronger economic growth (and a renewed positive attitude). Even aside from needed reform, there’s a conflict in these objectives. Ultimately, maintaining negative real bond yields – deemed a key element to reducing debt burdens – will be inconsistent with sustained moderate inflation and healthy growth. At some point, financial market expectations will adjust, and bond yields will rise.

Bad deflation vs healthy price declines

Deflation stemming from insufficient demand and growth-constraining economic policies can drain confidence and become negatively reinforcing, as Japan has shown. In such situations, aggressive macroeconomic policy stimulus designed to jar expectations and boost demand is appropriate. Europe’s downward price and wage pressures are necessary adjustments to its earlier excesses, and relying excessively on aggressive monetary policy to stimulate demand is not a lasting economic remedy. Europe is not destined to fall into a Japanese-style prolonged malaise, but it must continue to pursue reforms that lift productive capacity and confidence.

The US situation is very different. The economic expansion is gaining momentum (temporarily sidetracked by unseasonal winter storms), unemployment is falling steadily, personal income is growing faster than inflation, and household net worth is at an all-time high. Expectations of deflation are not apparent in either household or business behaviour. Concerns about lingering labour-market underperformance are warranted; angst about deflation is not.

Prices of some goods and services in the US have been falling, benefitting from technological innovation, improved product design, or heightened competition and distribution efficiencies through the internet. Examples abound: flat-screen TVs, computers, automobiles, reduced fees on financial transactions, online consumer and business purchases, etc. These lower prices and quality improvements explain the vast majority of the recent deceleration in inflation – the PCE deflator for goods continues to decline and is flat for nondurables, while it has been rising at a fairly steady pace of 2% for services.

These innovation-based price reductions improve standards of living and free up disposable income to spend on other goods and services. They boost aggregate demand and enhance economic performance. And they contribute positively to longer-run potential growth.

It is unclear why US policymakers and commentators fear disinflation that stems from innovation-based price reductions amid accelerating aggregate demand. European policymakers face tougher choices.

Figure 4. Decomposition of the US PCE deflator

Topics: Global crisis, Monetary policy
Tags: deflation, disinflation, Europe, eurozone, Japan, quantitative easing, US

Chief Economist, Blenheim Capital Management