Global: One Recession Away from Deflation
By Stephen Roach
Morgan Stanley / (New York)
Feb 21, 2003
Just like that -- many have been quick to call off the deflation alert. An oil shock, surging commodity prices, and now a 1.6% monthly spike in January?s Producer Price Index all seem to be hinting more of incipient inflation. Yet, in my view, it would be entirely premature to issue the ?all clear? signal on the deflation front -- especially in light of conditions in the world?s three largest economies. Japan is still in deflation and Germany, Europe?s dominant economy, is hardly out of danger. Meanwhile, America?s GDP-based inflation rate averaged just 1.0% in the second half of 2002, closer to the precipice of deflation than at any point in nearly half a century. Consequently, notwithstanding the recent resurgence in commodity prices, it wouldn?t take much for disinflation to morph into outright deflation. My concern is that another recession -- hardly a low-probability outcome with oil prices now in the danger zone -- could well be the trigger for just such an outcome.
The case for deflation rests on three key premises: First is the post-bubble legacy of excess supply -- especially the overhang of redundant IT capacity that was put in place in the United States and Asia in the latter half of the 1990s. While America?s IT correction was fast and furious over the 2001-02 interval, the rest of the world has not been as quick to follow. Europe?s telecom carnage is an obvious exception but non-Japan Asia?s ongoing appetite for new IT capacity -- especially China -- has been an important offset. Against the backdrop of a post-bubble compression of aggregate demand, the world remains awash in excess supply. That?s a classic deflationary condition.
Globalization is a second force behind the deflation story. Courtesy of accelerating growth in world trade, the globalization of supply chains changes the balance between aggregate supply and demand. That is not only the case in tradable goods -- the so-called China factor comes to mind -- but is also evident in the ?non-tradable? services sector. With service sector deregulation now a global phenomenon, surging cross-border M&A activity creating huge multi-national service behemoths that span the globe, and the Internet spawning the advent of IT-enabled service exports from countries such as India, service-sector supply curves have gone from being national to global. That magnifies the overhang of aggregate supply -- yet another reason for global pricing to adjust downward.
But the latest twist can be found in the business cycle, the third piece to the deflation puzzle. Recessions are, by definition, deflationary events. Since the world economy entered its last recession in 2001 at a very low inflation rate -- a 1.3% increase in the advanced world GDP deflator in 2000, according to the IMF -- a close brush with outright deflation can hardly be judged a shock. In the parlance of macro, this recession opened up a positive ?output gap? as a deficiency in aggregate demand and, in the context of excessive aggregate supply, virtually destroyed any semblance of pricing leverage for most global businesses. Normally, cyclical recoveries promptly close the gap between supply and demand, thereby restoring pricing leverage. That has not been the case in the decidedly subpar recovery that has occurred in the aftermath of the 2001 global recession. By our estimates, a 2.6% increase in world GDP in 2002 -- versus a longer-term trend of 3.6% -- actually led to a further widening of the global output gap and a concomitant increase in deflationary pressures. Against this backdrop, it would now take a fairly vigorous recovery in the global economy -- several years of world GDP increasing in excess of 4% -- to tilt the business cycle away from deflation.
Yet precisely the opposite now seems to be in the cards. Courtesy of a full-blown oil shock, the world is now flirting with yet another recession. Crude oil prices (as measured on a West Texas Intermediate basis) are now around $37 per barrel. Not only does that represent an 87% increase from levels prevailing at the start of 2002 (an average of $19.69 in January 2002), but today?s prices ($36.79 as of the close on 20 February) are nearly identical with the highs hit on 20 September 2000 ($37.20) that played a key role in triggering the recession of 2001. Unfortunately, oil shocks and recessions go hand in hand. That was not just the case in 2001 but also the outcome in the aftermath of the first OPEC shock of late 1973, as well as the result of the spike associated with the Iranian Revolution in 1979. And, of course, the same was the case following the sharp run-up in oil prices leading up to the Gulf War. In other words, show me an oil shock and I?ll show you a recession. It?s hard to believe that the current oil shock will be the one exception.
Another recession at this juncture could well reinforce the cyclical piece of the case for global deflation. Our global forecast is currently ?under review? as we assess the twin impacts of looming war and higher oil prices. Our baseline scenario for 2003 world GDP growth currently stands at 2.9%. While I do not want to prejudge the outcome of our deliberations, I would place the ultimate downside somewhere in the 2.0% to 2.5% range. With global recession widely viewed as anything below the 2.5% world GDP growth threshold, there can be no mistaking the potential consequences of this oil shock -- a second worldwide downturn in two years. But the key insofar as the macro-analytics of deflation are concerned is the implications for the global output gap -- the discrepancy between aggregate supply and demand. When judged against the world economy?s 3.6% long-term trend line -- a good proxy for potential growth, or global supply -- a sharp downward revision to our 2003 baseline forecast has critical implications for the global output gap. Taking the midpoint of the 2.0% to 2.5% world GDP growth range noted above as an illustration, that would represent a 1.4-percentage-point shortfall from trend. Such a further widening of the global output gap would come on the heels of a 2.4 percentage point shortfall that opened up over the 2001-02 interval. That would bring the cumulative shortfall from trend to nearly four percentage points since 2000 -- large by any standards of the past.
Therein lies the risk. In my view, it was the widening of the global output gap in 2001-02 for a low-inflation world economy that led to the subsequent lack of pricing leverage and the close brush with deflation. And now -- courtesy of another oil shock -- that global output gap is set for a sharp further widening. As I see it, that can only intensify the lack of pricing leverage, taking the world all the closer to the brink of outright deflation. In other words, the current oil shock should not be interpreted as an inflationary event along the lines of the outcomes of the 1970s. It is, by contrast, very much a deflationary shock. Prior to this oil shock, I would have depicted the world economy as being only one recession away from deflation. To the extent that recession may now be in the offing, the case for deflation actually looks more compelling than ever.
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