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Tuesday May 25, 2010 - 10:50:18 GMT
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Deflation Threatens, Policy Response Limited (FXA)

With US core CPI up 0.9% year-over-year in April, the lowest annual rate since 1966, and core PCE price index up 1.3% year-over-year in March, the US economy is not generating much in the way of inflation.  And going from low inflation to negative inflation is a short hop skip and a jump when the unemployment rate is nearly 10%, private demand is anemic, housing sector wobbly and on the verge of another downturn, exports facing headwinds from a firm dollar and weak external demand, a still non-credit creating banking system and fiscal policy effects on the down hill side of peak impact. 


While it would be hubris to forecast a deflationary spiral ahead, the risks of a broad decline in prices driving savings up is still a risk for the US and global economy.  Deflation also implies falling asset prices and falling household net worth (lower real estate and equity prices).  So I ask what can be done, from a policy point of view, if deflation threats build in the next few quarters?


Well BOE MPC member Posen noted today that nothing can be expected from fiscal policy makers ahead in the UK if deflation were to rear its ugly head.  Posen, a student of Japan’s lost decade (more like lost decades) also argued that the US and UK are not Japan when it comes to preventing deflation from taking root…both are more open and dynamic economies, even if the fiscal firepower is more limited than Japan’s was in the 1990’s.  Looking at US politics ahead of the November 2010 mid-term elections I would argue that the door is pretty firmly shut on another fiscal policy stimulus.  The UK government led by the Conservatives was elected on a pledge to cut the deficit…today Chancellor Osborne outlined GBP6.5bln in savings…and more will be forthcoming in the next budget.


The Euro Zone is frantically reining in fiscal stimulus…even in countries where the economy is in serious contraction…arguably already in deflation…Greece and Ireland come to mind.  Even Germany is unveiling budget cutting measures.  And EU finance ministers under the urging of the German government are contemplating changes to the EU Treaty that would strengthen fiscal policy compliance with stricter sanctions.


Europe is done fiscally.  The US is all but done on fiscal stimulus at least through the November 2010 election and only after if the Democrats retain majorities in the House of Representatives and the Senate. 


Japan is at its debt limits too…worse debt to GDP than Greece…assumption here is that this homogeneous and compliant population will bequeath its huge private savings to the government to pay down the debt at some point in the future.  But the government is debating limits on JGB issuance ahead and the prospects for Japan’s enormously unpopular government to spend its way to prosperity is severely limited. 


The only seemingly unconstrained fiscal provider on the planet appears to be China which has instituted a number of large and powerful, not to mention effective, fiscal stimulus packages.  But even here the government is not eager to keep writing checks to drive domestic investment indefinitely (increasing capacity) at a time when the outlook for global exports is questionable at best. 


So it all boils down to central banks.   With the BOE and Fed in quantitative easing mode and looking for a way out, there is reason to think that neither central bank will volunteer to adding to balance sheet expansion anytime soon short of a serious dose of financial contagion…a run on the banking system.  The ECB has scope to do much more but not the stomach for it and an awesome if dogmatic excuse…sole mandate of price stability and this is an asymmetric mandate…inflation bias.   ECB could cut the refi rate to zero or near zero and leave its bond purchases unsterilized (admittedly there is reason to believe that the ECB is not really sterilizing the purchases as they accept term deposits as collateral for loans).   The BOJ is not inclined to do more – not even with the cabinet breathing down its neck to do more. 


Heaven help us if there is a more serious round of financial contagion ahead…the European debt crisis has driven LIBOR out to the highest rates since July of 2009, though well under the peak rates of 2008.  And there are signs that European banks are having a harder time issuing CP at rates and maturities that US money market funds want…regulatory changes over this body of asset managers is changing at the end of the month mandating that 30% of securities held are for 7 days or less while most bank CP programs are 3 and 6 months.   I suspect the ECB is going to get a rude awakening in coming days as European banks turn to the central bank for more funding. 


So we need to pray that stocks go up and the shape of the recovery is V-like, not W, not U, not L and not I.  I can’t help of thinking of the predicament BP engineers are in right now off the coast of Louisiana when contemplating the job ahead for the world’s central banks. 


David Gilmore




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