Deflation is certainly something to worry about, but, given the determination of politicians to fight it, inflation could make a rapid comeback. John Stepek reports.
So much for the V-shaped recession. The hope that America would experience a mild dip before making a storming recovery was wiped out this week with news that the economy has been in recession since December 2007. While this won’t have come as much surprise to MoneyWeek readers, it was an unpleasant shock for all those who’d hoped this would all be over by next summer. As Albert Edwards at Société Générale points out, this is already the third-most extreme US recession since the Great Depression – and “it’s likely to be the longest and deepest since then”.
The problems are, of course, not restricted to America. The eurozone and Japan are also officially in recession, making it the first time since World War II that all three have been contracting at the same time. Activity is collapsing around the world. For example, in China, November’s Purchasing Managers Index showed that the country’s industry was shrinking at its fastest rate on record (see: China heads for a hard landing). Manufacturing in Russia, Britain and the US is in similar straits.
The entire world has become dependent on the ability of the US consumer to keep spending. But with the housing bubble popped, and credit ever harder to come by, US consumers are out of money. As Morgan Stanley’s Stephen Roach puts it in the FT, “never before has there been such an extraordinary capitulation of the American consumer”. This collapse hurts anyone who makes things for Americans to buy, and everyone who relied on selling raw materials to those manufacturers. In China, construction of houses, offices and factories fell by nearly 17% year on year in October, reports Macquarie Securities. Jim Walker of Asianomics tells Bloomberg that global growth could slow to “close to zero next year”.
And as demand dives amid tighter credit, prices are collapsing, with the cost of everything – from houses to cars to copper – on the slide. Prices are collapsing at such speed that people now fear something that’s not been seen in the UK or US for some time: deflation.
What’s so bad about deflation anyway?
From being the major worry for central banks across the world, inflation has very quickly become yesterday’s problem, tumbling as oil and commodity prices across the globe fall. In Britain, Consumer Price Index (CPI) inflation fell to 4.5% in November. That’s still well above the Bank of England’s target of 2%, but it’s tumbling fast. Capital Economics reckons that CPI in Britain could fall “as low as -1.5% by next autumn”. And consumer expectations are falling too. The British people expect the CPI rate to fall to just 0.9% in the next 12 months, from expectations of 2.9% in October – the biggest monthly drop seen on the survey since it started in 2005.
But, you might ask, what’s so bad about falling prices? Well, if you don’t have any debt, and you can keep hold of your job and income, then nothing. Despite popular belief, the argument that people put off consumption because of falling prices doesn’t really hold water – if that was the case, no one would ever buy a laptop or a TV.
But the trouble is that deflation feeds on itself. Prices start slumping because there’s less money available, and thus less demand. Shops have to slash the cost of their products, profits fall, so people lose their jobs as firms cut back or go bust. Another pressure on company profits is that wage growth doesn’t easily fall below 0% a year – even if 0% is a rise in real terms, getting people to accept a pay cut “in line with deflation” is harder than it sounds. As job losses rise further, demand keeps falling, which produces more deflation.
During the Great Depression, the US consumer price index fell by 24% between 1929 and 1933, says N. Gregory Mankiw in The New York Times, while unemployment rose from 3% to a staggering 25% over the same period. Deflation also makes debt more costly to service – while inflation decreases the real value of your borrowings, deflation increases it. That makes deflation especially bad news for heavily indebted societies such as America and Britain.
Proponents of the Austrian school of economics would argue that deflation isn’t something to be prevented. As Jorg Guido Hulsmann says on Mises.org, “deflation is a very efficient mechanism to speed up adjustment to new circumstances in the wake of a major financial crisis”. After all, the slump has arisen as a result of ill-considered monetary policies during the boom. Allowing things to take their course would clear out bad investments made during the boom period. It’d be painful – but that’s what happens when you let bubbles get too big.
While we have sympathy with that view, it’s not what’s going to happen. At least, not until the world’s governments and central banks have exhausted every other possibility. As Gordon Brown has become fond of saying – and it’s an attitude shared by politicians around the world, fearful of recession-struck voters – “doing nothing is not an option”. But just what can they do?
The Fed’s next trick
As the world’s most influential central bank, it’s safe to say that all eyes are on the Fed for the next move. Central banks usually influence the economy by raising or lowering the cost of money. The Fed, for example, does this by making more or less money available to the system via the sale and purchase of government debt to key banks. But with the major American interest rate, the Federal Funds rate, already at 1%, it may seem that there’s not much more the Fed can do. After all, rates can’t go below zero. But that isn’t the only tool it has up its sleeve.
The Fed is moving from targeting interest rates to targeting the money supply directly. This policy is known as ‘quantitative easing’ and was adopted by the Bank of Japan in 2001 to try to shake Japan out of its stagnation. The Fed does this by, in effect, printing money to buy Treasuries or other securities from banks to boost their reserves and get them lending again. The US central bank has already got to work, says John Higgins at Capital Economics. “The speed and scale of the Fed’s quantitative easing puts the past efforts of the Bank of Japan firmly in the shade.” In fact, “it’s easy to lose track of the efforts being undertaken by the Fed to get money flowing freely again in the economy”. The Fed’s balance sheet has more than doubled in size in the past 11 months, says Jack Willoughby in Barron’s, from $915bn to $2.2trn. It has provided “so many loans and emergency credits – to banks, brokers, money funds and foreign countries – that its balance sheet, viewed one way, is as leveraged as any hedge fund’s”.
But will it work?
So far, not as the Fed may have hoped. The Fed’s moves “certainly could be” inflationary, says Dwight Cass on Breakingviews, but currently “inflation isn’t a pressing concern because banks aren’t making loans”. As Alex Merk of Merk Investments points out on MarketOracle.co.uk, “the Fed can provide all the money it wants, but it cannot force institutions to lend”. Banks are hoarding the extra money the Fed gives them – ‘excess reserves’ have jumped from $2bn in August to more than $600bn now.
Indeed, James Ferguson of Pali International argues that the sheer scale of deleveraging means that even central banks’ money-pumping efforts won’t result in inflation. New York University professor Nouriel Roubini agrees. In the FT, he writes that credit losses are likely to reach “a staggering $2trn”, and expects 2009 to be “a painful year of global recession, deflation and bankruptcies”.
But others aren’t so sure. The Fed can do more than just lend to banks – it can lend direct to the government, which it can rely on to spend the money. “Creating inflation is not rocket science,” says former IMF economist Kenneth Rogoff in The Guardian. “All central banks need to do is keep printing money to buy up government debt.” In other words, when the government needs money, it simply writes itself a cheque.
David Rosenberg at Merrill Lynch reckons that “this sounds like a template for what we are going to see unfold here: a huge fiscal stimulus, but instead of the Treasury financing it by selling bonds to the public, it will be the Fed that finances the plan by buying the Treasuries and expanding its balance sheet (ie, printing money to fund the deficit).” As Hugh Hendry of Eclectica Asset Management points out, if deflation gets bad enough in America, Bernanke has the power to turn around to Congress and say: “You guys ain’t spending enough – I want you to spend $3trn.” And if that doesn’t work, he can ask for “$20trn”.
As to why quantitative easing hasn’t sparked massive inflation in Japan, Hendry points out that Japan started out from a far stronger position than the US. “Japan went into its slump as the world’s largest creditor nation. The US doesn’t have 18 years to think about its options.” This is a crucial difference between America and Japan – the former has much more incentive to inflate its way out of its problems.
Foreign investors own just over half of the $7,400bn Treasuries outstanding. Just as debt-laden consumers struggle under the weight of their debt burdens, so Dominic Konstam at Credit Suisse tells the FT: “a debtor nation can’t sustain deflation”. If the Fed is buying up mortgages and perhaps even Treasuries, foreign investors may ditch US assets as the country tries to inflate its way out of its obligations.
Then there’s what could be described as the nuclear option – intervening directly in the foreign-exchange markets. Bernanke himself pointed out in his 2002 speech, ‘Deflation: making sure ‘it’ doesn’t happen here‘, that “there have been times when exchange-rate policy has been an effective weapon against deflation”. He cites (approvingly) Franklin Roosevelt’s 40% devaluation of the dollar against gold in 1933-1934. “The devaluation and the rapid increase in the money supply it permitted ended the US deflation remarkably quickly.” It’s the sort of comment that should have any foreign investor in America getting somewhat nervous about their prospects. Even more so when they remember that, in the same speech, Bernanke swore “that the Fed would take whatever means necessary to prevent significant deflation in the United States”.
And although the yield on Treasuries and gilts has continued to fall, the cost of insuring against the US government (and the UK’s) defaulting on its debts has risen sharply. The gap between the price of credit default swaps (CDS) protecting against default by the German government and the cost of CDS on American ten-year debt has hit a record high of 20 basis points (0.2%). “There is a question mark over US sovereign credit and it’s going to persist,” Ken Wattret at BNP Paribas tells Bloomberg.
So the scene is set for a massive tug of war between the forces of deleveraging and a Fed chairman determined to avoid deflation. As Edwards puts it, “for the first time in my working career, I haven’t got the foggiest about what will happen beyond about one year out. We’re in a massive policy experiment.”
At MoneyWeek, we have a suspicion that inflation will be making a comeback more rapidly than most investors are now expecting. Global bad debts may be vast, but they’re finite. Technically, the Fed can print as much money as it wants to, so if Bernanke is determined to beat deflation, he probably can. He may assume he can clear up any inflation problem afterwards – but as Rogoff points out, the main risk with ‘quantitative easing’ policies is that “inflation could overshoot, landing at 20% or 30% instead of 5%-6%.”
That’s further down the road. For now, it’s pretty much certain that we’re going to see deflation, and that means that for now, it’s still time to buy gilts. But we also have a few suggestions below as to how to hedge your bets for what might come after.
How to hedge against deflation
If we’re facing deflation in the short-term, followed by a return to much higher inflation, then what should you invest in? In terms of stocks that will do well in deflationary times, Albert Edwards at Société Générale points out that defensives outperformed in Japan during its deflationary times. So classic defensives, including pharmaceutical stocks, such as GlaxoSmithKline (LSE:GSK) and AstraZeneca (LSE:AZN), should do better than the rest of the market.
For the shorter term, Hugh Hendry at Eclectica Asset Management is still backing government debt. Hendry likes German 30-year bonds. Another easy way to get exposure to British Government debt is via the Barclays iShare IGLT exchange-traded fund (LSE:IGLT).
However, while James Ferguson of Pali reckons that the government debt boom will run for some time, we’re not quite so sure. As David Rosenberg of Merrill Lynch points out, it looks like the US Treasury market is heading into the “home stretch of this massive bull market”. The yield on the ten-year Treasuries (bond yields fall as prices rise) has hit its lowest level since April 1954. Rosenberg reckons Treasuries “have now moved into overvalued territory”, though this overvalued condition is likely to persist as the Fed, households and institutional investors emerge as large-scale buyers. “Even investors who say bonds are expensive are enticed to buy the debt for fear of missing out on even more gains,” says Bloomberg. “We’re on new ground,” says one US fund manager. “You just wonder if you’re going to be the last man in.” Certainly, that kind of talk suggests that we might be seeing a bubble building in bonds.
In fact, Hendry reckons that the bond bull market “could well be over by the second quarter of next year”. He suggests that – as with all bubble investing – investors should set themselves a target and bail out once they’ve hit it. He suggest using the ten-year Treasury as a benchmark, and once it breaches the April 1954 record low of 2.3%, that’s when investors should sell whatever exposure to government bonds they have, and start looking towards investing for more inflationary times. Then it will be time to look at inflation-linked bonds, which have fallen sharply as investors worry about deflation. You can buy into index-linked gilts via the Barclays iShares Index-Linked Gilt fund (LSE:INXG).
Of course, the other classic inflation hedge is gold. In a recent note from Citigroup, strategist Tom Fitzpatrick predicted that gold could go as high as $2,000 an ounce. Of the Fed, he says “they are throwing the kitchen sink at this… the world is not going back to normal after the magnitude of what they have done.” Yet even if the reflation attempt doesn’t work, Fitzpatrick reckons investors should hold onto the yellow metal – because if the Fed fails, it will be because “too much damage has been done”, which would cause “further economic deterioration” leading to “political instability” and civil unrest. With faith in government – and by extension, government-backed currencies – shaken, gold would also rally higher. The bank reckons the price could rise as early as 2009, reports Ambrose Evans-Pritchard in The Daily Telegraph.