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Should Americans be afraid of Deflation?

US CPI numbers have been declining for several months now – the latest print for January saw CPI fall -0.7% , the fourth consecutive month of deflation. Financial markets across the world are bracing themselves for a sustained period of deflation and digesting the potential policy implications this might have for the Federal Reserve. Deflation is a decrease in the general price level of goods and services within the economy and usually occurs when the level of overall demand is insufficient to meet supply.

The bond market is suggesting a revised timing scenario of the Fed’s next move in rates- from an expectation of a 0.25% increase in June delayed until September. This is a significant change as several vulnerable asset classes such as Emerging Markets, High Yield Credit, and Equities have all been gingerly awaiting a rise in Fed rates for some time. An alteration to the time schedule of any increase in rates will have huge implications for these markets – we are already seeing this occur.

If the mere glimpse of deflation in the official numbers is enough to have such a dramatic effect on market expectations – it is important to establish where the current sources of deflation are coming from and how these influences are likely to evolve going forward.

Deflation is Public Enemy #1 for Central Banks

Deflationary Spiral

Deflation has always been a major concern for market analysts and commentators as it points to a structurally weak economy incapable of generating the demand required for sustained growth. Deflationary environments are often characterized by an above average rate of bankruptcies which tend to reverberate throughout the entire economy. Oversupply in a particular industry often leads to extreme discounting – this can be so severe to the point where prices no longer cover costs. Once this level is breached, factories and businesses are forced to shut down, which leads to increased layoffs and unemployment. As incomes drop, overall demand decreases further within the economy until a deflationary spiral begins to draw the economy deeper and deeper into recession.

Periods of sustained deflation are unusual economic events but there are some spectacular historical examples – the Great Depression of the 1930s being the most prominent.

The impact that the Great Depression has had on the psyche of economists is profound.

Keynesian economic theory, the backbone of nearly all current economic policies adopted by central banks across the world, was formed in direct response to the horrifying economic events of the Great Depression. Keynesian theory advocates increased government intervention in the economy by adopting an expanded money supply and increased spending during an economic downturn. Central Banks across the world are currently enforcing these theories through their Quantitative Easing programs and zero interest rate policies. Although these policies have had some effect in boosting the prices of certain financial assets and reducing the official unemployment figures – the lack of official inflation is likely to give the Fed considerable room to keep rates unchanged going forward – and this is most likely a result of the crashing price of Oil.

Canary in the coal mine – Crude Oil

Canary

Oil is the life blood of our modern economies. Nearly all aspects of our industry, agriculture, technology, entertainment, and social lives are built in one way or another on the foundation of Oil. The recent rout in Oil prices is flagging severe stress within the global economy – January inflation figures highlighted a 9.7% drop in Energy prices and a 18% drop in gas prices. At first glance declining Oil prices may seem like a good thing – gas and heating bills are reduced leaving consumers with more money to spend on other goods services. In reality, it never tends to work out this way.

The rout in global Oil prices is likely the direct result of massive overcapacity within the global economy – the most probable cause is China, but finding the exact source of this overcapacity is unclear – an analogy would be trying to find the starting point of a particular strand of spaghetti within a giant bowl. The global economy is an interconnected mess. Nevertheless, the knock on effect which decreasing Oil prices are having is considerable. Any business or country heavily reliant on commodities is currently feeling extreme financial duress. We are likely to see increasing levels of bankruptcies begin across the commodity sector within the US and globally. The shale gas industry in the US is at particular risk – this has repercussions for the banking industry and credit markets in general.

As these global factors continue to unravel – CPI within the US is likely to remain subdued. Global deflationary forces could very well end up causing the Fed to postpone its well flagged rise in interest rates – the market is already starting to price this scenario in. Upcoming CPI figures for February, to be released later this month should continue to confirm the deflation trend that we are currently experiencing. If the deflation figures overshoot, then we could start to see some real upheaval in world financial markets going forward.

Andrew

Andrew

Guest Contributor at CPI Inflation Calulcator
Andrew McCarthy is an expert in all things inflation. He has a Bachelors in Economics and has been working in the finance industry for over two decades.
Andrew