Global: A Deflationary Mosaic
Stephen Roach (New York)
morganstanley.com
I continue to believe that the balance of risks on the price front has shifted away from inflation to deflation. The evidence, in fact, is building that more than a casual whiff of deflation is already in the air in the United Sates. Unfortunately, that’s exactly what the model of the post-bubble economy would predict -- an overhang of excess supply that could lead increasingly to widespread price destruction. How serious is this risk?
Deflation, in the strict sense, is defined as an outright decline in the national price level. On that count, the United States has yet to qualify. Only one of the major price gauges -- the Producer Price Index -- is flashing any meaningful deflation at this point in time. The PPI for finished goods was down 1.1% on a year-over-year basis in July 2002; moreover, prices of intermediate producer goods were down 1.5% over the same period, whereas prices of crude materials goods are off at a 6.2% annual rate. By contrast, inflation, as measured by the Consumer Price Index, was running at a positive +1.1% year-over-year rate in June 2002. Moreover, the broader GDP chain-weighted price index is sending a similar verdict -- a +1.0% year-over-year inflation rate in 2Q02. While these trends are exceedingly low by standards of the past 50 years, they still leave the US economy in the positive inflation zone -- at least for the moment.
Swings in the aggregate price gauges can often mask some important shifts in the mix of pricing. That’s certainly the case today. A product-based decomposition of the broad GDP price index into goods, services, and structures underscores this point. As seen through this lens, the only reason the GDP-based inflation rate is holding in positive territory is a +2.2% year-over-year inflation rate in services -- a vast but amorphous segment of the economy where there are notorious pitfalls to price measurement. For the remainder of the product mix -- goods and structures combined, which collectively account for fully 47% of real GDP and 44% of nominal GDP -- our estimates suggest that prices were actually 0.6% below their year-earlier level in 2Q02. For goods -- which, alone, make up 35% of nominal GDP -- there has been outright deflation of -0.8% on a year-over-year basis through 2Q02. A recent article in the Wall Street Journal underscores a similar conclusion, with a product-by-product scrutiny of the hundreds of items in the CPI market basket revealing that about 30% of the categories were registering year-over-year declines as of June 2002. (see "Deflation Makes a Comeback," August 13, 2002).
For structures -- with inflation measured by the price of the construction project rather than by the change in the value of the asset -- GDP-based inflation has slowed to just a +0.9% rate over the past year. That’s down sharply from the post-1983 cycle high of 5% hit in 1Q01. On that latter count, I must confess to a careless error that crept into an earlier discussion of this shift in the mix of inflation (as published in my August 5 dispatch, "The Post-Bubble Business Cycle"). In that essay, I noted that the price of structures was running 0.9% below its year-earlier level. It turns out I got the 0.9% right but unfortunately reversed the sign in my late-night fatigue. Mea culpa. Notwithstanding that dyslexic error, the basic point remains very much intact -- a little less than half the US economy is now in the throes of outright deflation.
The hows and whys of America’s deflationary perils will long be debated. A bubble-induced imbalance between aggregate supply and demand is central to my own thinking. To the extent that asset bubbles create artificial stimulus on the supply side of the equation -- precisely the point with America’s IT-led capital spending binge of the late 1990s -- price destruction should hardly come as surprise. Also at work are the unmistakable impacts of globalization. The US economy is more open than ever. Goods imports stood at 33% of goods GDP in 2Q02 -- down only fractionally from the record high of 35% hit in late 2000 and well above the 20% shares that prevailed, on average, at the onset of the last two cyclical recoveries in the early 1980s and early 1990s. Reflecting the legacy effects of the strong dollar, in conjunction with the weakened state of global demand, nonpetroleum import prices were still running 1.5% below their year-earlier level in July 2002 following a 2.4% deflation over the preceding 12 months. Importing deflation is not that big a deal in a closed economy. In today’s increasingly open US economy, it’s a different matter altogether.
In the end, it’s always about pricing at the margin. Courtesy of globalization, low-cost foreign producers are playing an ever-important role in shaping the aggregate US price level. Nowhere are those impacts more evident than from China -- now America’s third-largest source of imports (behind Canada and Mexico). In the first five months of 2002, Chinese products accounted for 9.3% of total goods imports into the US, a sharp increase from the 7.7% share in the first five months of 2001. Moreover, China is now experiencing a deepening of its own deflationary pressures; with its overall CPI falling 0.9% on a year-over-year basis in July -- continuing the latest deflationary trend, which reemerged in November 2001. To the extent that ever-cheaper Chinese imports are gaining market share in an increasingly open US economy, a significant portion of America’s deflation could well be made in China.
Deflationary perils also have important implications for the bond market, especially with yields on the 10-year Treasury note now flirting with the all-important 4% threshold. Interestingly enough, the bulk of the recent rally does not appear to reflect heightened concern over deflation. At work, instead, has been a dramatic reduction of real interest rates stemming from intensified double-dip related concerns over a weak US economy. The yield on a 10-year TIPS (Treasury Inflation-Protected Securities) has fallen from around 3% at midyear to just 2.38% at today’s close. By contrast, the implied inflationary premium -- calculated as the difference between the nominal and TIPS-based real yields on the 10 year Treasury -- has held at approximately 170 bp over the past several weeks. While this is well below peak readings of around 220 bp hit earlier this spring, it is more than 100 bp above the 60 bp lows hit in late 1998 during the full-blown deflationary scare that occurred in the depths of the Asian currency crisis. In other words, even at today’s exceedingly low levels of nominal interest rates, it does not appear that an outright deflationary scare is currently in the price of long-dated Treasuries. There’s an important corollary to that observation: Shocking as it may seem, I believe long rates could actually fall a good deal further from today’s rock-bottom levels if fears of outright deflation were to intensify.
As this diagnosis of the bond market suggests, there is still a good deal of denial over the risks of a US style deflation. Most believe it’s too much of a Japanese-like scenario to happen in America -- that the United States must be unique. But is it? Sure, there are many important differences between America and Japan. Yet post-bubble economies always seem to have one thing in common -- they are far more deflationary-prone than most believe. As I also documented in my August 5 essay cited above, that’s exactly what’s been the case in this business cycle -- a deflationary outcome that has been far in excess of those of earlier cycles. GDP-based inflation currently stands at 1.0% (in 2Q02) -- down 1.3 percentage points from its pre-recession peak of 2.3% hit six quarters earlier (in 1Q01). That’s nearly double the 0.7-percentage-point deceleration of inflation recorded over comparable periods of the past six cycles. In other words, a post-bubble, low-inflation US economy is already in the throes of an unusually intense disinflationary shakeout. As a result, America is now closer to the brink of outright deflation than at any point in the past 48 years.
The United States is not Japan. But that doesn’t mean we shouldn’t heed the important lessons of Japan. It’s time to stop pretending that deflation can’t happen in America. |
