|
Deflationary cliff Original Source Link: (May no longer be active)
http://afr.com/marketwrap/money/2002/12/09/FFXF4X9TF9D.htmlhttp://afr.com/marketwrap/money/2002/12/09/FFXF4X9TF9D.html
M O N E Y
--------------------------------------------------------------------------------
FEATURE
Alarm bells ring at Fed
Dec 9
Peter Hartcher
It was a conference to mark Milton Friedman's 90th birthday last month, and who should give the toast to the world's most famous monetarist? A governor from the US Federal Reserve, naturally.
The man from the Fed, a monetary expert in his own right, Ben Bernanke, delivered a dense, 10-page tribute to Friedman's contribution to modern economics, then this punchline: "Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton ... regarding the Great Depression: You're right, we did it.
"We're very sorry. But thanks to you, we won't do it again."
A couple of weeks later, seemingly following through on this pledge, Bernanke delivered an unprecedented speech in Washington DC. The title: "Deflation: Making sure it doesn't happen here."
It was the Fed's emergency plan, the economic equivalent of the The Worst-Case Scenario Survival Handbook
Bernanke laid out the extraordinary measures the Fed could take - including buying assets from private companies - if the US economy fell into that condition people associate most closely with the Great Depression - deflation, a fall in the general level of prices, the opposite of inflation.
If inflation is too much money chasing too few goods, then deflation is too little money chasing too many goods.
How close is the US to deflation?
Fed chairman Alan Greenspan told anxious members of Congress in October that "we are not close to the deflationary cliff". But how good are his forecasting skills? The Fed, by its own admission, utterly failed to foresee Japan's slide into deflation seven years ago.
And a solid core of serious analysts now believes it to be a very real risk. The Fed's own behaviour betrays a distinct unease. A month ago it cut the key official interest rate by an aggressively large increment - from 1.75 per cent, already the lowest in over 40 years, to 1.25 per cent.
Fed officials have called that move insurance. Although the financial markets think there is little chance that the Fed will cut rates again at its policy meeting this week, "the Fed is, I won't say panicked", says Steve Roach, economist for the investment bank Morgan Stanley, "but it is very much on alert".
The decision by President George Bush to replace his economic team last week is another indicator that American officialdom is alert to the need for decisive action to keep the economy from quicksand.
As the Fed's Bernanke says: "Sustained deflation can be highly destructive to a modern economy and should be strongly resisted."
Consider the evidence of deflation so far.
The broadest measure of price pressures in the US economy - the gross domestic product deflator - is barely above zero. In the year to the end of September, it was up by 0.83 per cent, its feeblest in half a century.
"The essence of deflation is that business leaders know they do not have pricing power," the ability to raise the price of their products, points out Wayne Angell, a former governor of the Fed and chief economist for the Wall Street investment bank Bear Stearns.
And the prices received by US firms overall have declined in each of the past five quarters, the longest run in more than 50 years. For the latest quarter, they were down 1.3 per cent.
At first, and sometimes for years, executives think that this lack of pricing power is temporary, due to a downturn in the business cycle, Angell says.
"They expect that pricing power will return with recovery." With deflation, it doesn't. "This is precisely what is happening in the US economy today."
Consumer prices in the US are still rising - by 1 to 2 per cent a year, depending on the measure. But David Rosenberg, an economist in the Canadian office of the US investment bank Merrill Lynch, points out that the price of 40 per cent of the hundreds of items that go into the basket to make up the consumer price index are falling.
Indeed, all the inflation in US consumer prices is coming from only five areas that make up a quarter of the index - housing, tobacco, car insurance premiums, hospital services and tuition.
"There's a compelling case for deflation," says Morgan Stanley's Roach. "We are in a rarefied and highly dangerous period."
The two top-most international finance officials in Japan last week took the warning even further. They declared that it was not just a danger facing the US - it was a risk to the entire world economy.
In an unorthodox move, the Vice-Minister for International Affairs at Japan's Ministry of Finance, Haruhiko Kuroda, and his deputy, Masahiro Kawai, put their case starkly.
"Monetary policymakers around the word are still fighting the old enemy of inflation, not the new foe of deflation," they wrote in the Financial Times.
"There is an urgent need to switch to global reflation in order to avoid a deflationary spiral." They called on the Europeans, Americans and Chinese to join Tokyo in heading off a global deflation. And the Japanese know something about contemporary deflation - they pioneered it.
The mainstream of US forecasters does not foresee deflation in the US. But then again, the mainstream does not have such an enviable record of forecasting - the consensus of US economists conspicuously failed to foresee the length of America's boom of the 1990s, and completely missed its 2000 bust.
What of Milton Friedman's school, the monetarists, whose believe that the supply of money is the key to inflation and deflation?
A respected US monetarist, Allan Meltzer, professor of political economy at Carnegie Mellon University and author of a new book, A History of the Federal Reserve, dismisses the possibility of deflation as nonsense.
"It's just bad thinking by badly trained Wall Street economists," Meltzer says. "I don't think any competent economist can make the case for deflation with M2 [the base money supply] growing at 8 per cent year on year and the economy expanding.
"You hear it from that Morgan Stanley guy, and his policy is being able to say, if something goes wrong, 'See, I told you so!', and he hopes that people forget the 800 times he was wrong."
What does the Morgan Stanley guy - Roach - have to say about this?
"I don't want to call a guy like Allan Meltzer simplistic ... but he's pretty consistent with his monetarist framework.
"With all due respect to him, the money supply may be growing, but there's no guarantee that it will go into consumption or prices. It's a circuitous route, at best - especially in an overindebted economy.
"Money can go into debt or saving; if you print enough of the stuff it will eventually spill over, but it's a long and arduous path."
It should also be pointed out that Roach's forecasting record is quite good, and better than most.
But even if you disbelieve the case for deflation, the most persuasive case for vigilance comes from the Fed itself.
An important research paper by 13 Fed staff economists, titled Preventing Deflation: Lessons from Japan's Experience in the 1990s, says: "Japan's deflationary slump was not anticipated. This was true not only of the Japanese policymakers themselves, but also of private-sector and foreign observers, including Federal Reserve staff economists.
"Moreover, financial markets had no better handle on the economy's prospects ... The failure of economists and financial markets to forecast Japan's deflationary slump in the early 1990s poses a cautionary note for other policymakers in similar circumstances: deflation can be very difficult to predict in advance.
"In consequence, as interest rates and inflation rates move closer to zero, monetary policy perhaps should respond ... to the special downside risks - in particular, the possibility of deflation."
Deflation is not necessarily a bad thing. The world economy has enjoyed booms while prices were falling, during the 1920s, for example.
But it looks malign at the moment for two main reasons. First, there is a kind of good deflation that happens when productivity is high and the economy is robust. This is not that kind of deflation. Today's deflationary pressures come from excess supply of goods and industrial capacity.
Second, deflation is especially dangerous now because the US has unprecedented proportions of debt. Why does this matter?
In an inflation, money loses value, so the inflation-adjusted value of debt shrinks as the years go by. So inflation is kind to borrowers.
But in a deflation, the opposite holds. Because prices are falling, the real value of money goes up in a deflation. So the value of debt actually rises, and borrowers are punished.
This can create a debt trap, forcing firms and families into a spiral of cutbacks to service a growing burden of debt - even though they're not borrowing a cent more. This pattern of retrenchment and bankruptcy can create recession and depression.
"We've already got debt deflation stories - we do have quite a large number of firms that are facing those kinds of pressures from unexpected sort of deflation already," says former Fed governor and leading forecaster Larry Meyer.
"And, as slack builds up in the economy, we're likely to see inflation fall below the implicit target" of the Federal Reserve, says Meyer.
"And, we know in those situations, again, following the lessons of Japan, that the policy authorities have to be particularly even more aggressive about pushing inflation back [up] to its target."
The Fed's contingency plan includes drastic options. If the key official interest rate should hit zero and the Fed loses its ability to stimulate the economy in the customary way - the current rate is already at 1.25 per cent - it could
buy up masses of government debt, even private corporate debt and private real estate, as a way of pumping liquidity into the economy. Fed governor Bernanke also points out that big devaluations of the US dollar have helped defeat deflation in the past.
Ultimately, "the US government has a technology, called a printing press ... that allows it to produce as many US dollars as it wishes at essentially no cost ... Sufficient injections of money will always reverse a deflation", he says.
Morgan Stanley's Roach says that the Fed's speech and its actions "are all very carefully orchestrated; they are shaping policies as if deflation is going to happen - and that's a good thing, because it is such a dangerous time".
|
|
