Deflation still unlikely, but mind the risks
This post is a guest contribution by Richard Berner* of Morgan Stanley.
Judging by the rebound in inflation breakevens, deflation risks have subsided. Five- and ten-year breakeven inflation rates have bounced sharply, the former from negative into positive territory; they now stand at 60bp and 110bp, respectively. Small wonder, given aggressive easing of monetary policy, the recent bump in commodity prices, the run-up in gold quotes, January US inflation data, and the recent rise in longer-term consumer inflation expectations.
Thanks to aggressive monetary easing and coming corporate actions to cut capacity, we don’t think that deflation is the most likely outcome. But investors should not entirely dismiss deflation risks, as tumbling operating rates are eroding pricing power. We think that uncertainty in the inflation outlook is now a key driver of those expectations and of breakevens. From a tactical perspective, therefore, our interest rate strategists, Jim Caron and George Goncalves, believe that inflation insurance in the form of breakevens should be sold for now.
There is no mistaking the upturn in some inflation determinants. Partly to combat the risk of deflation, the Fed has gone to a zero interest rate policy and is conducting ‘credit’ and quantitative easing. The CRB raw industrials index has moved up about 5% in the past 45 days following a 35% plunge over the last eight months of 2008. Spot gold prices have jumped US$300 to nearly US$1,000 since November. Empirical work at the Bank of Canada suggests that gold prices are a good leading indicator for inflation for several countries (see Greg Tkacz, “Gold Prices and Inflation”, Working Paper 2007-35, June 2007). And longer-term consumer inflation expectations are climbing again; measured by the University of Michigan’s canvass, 5-10-year inflation expectations have bounced 40bp to 3% in the past two months.
Moreover, recent inflation readings seem to belie a move to deflation. On the one hand, the plunge in energy quotes has pulled year-on-year headline inflation into negative territory, with a decline in the CPI of 0.2% in January from a year ago; last July, soaring energy quotes pushed headline inflation to 5.5%. But core inflation is still strongly positive and has declined more slowly, reflecting the lags between the time that slack in the economy increases and inflation falls. Measured by the change in CPI from a year ago, inflation excluding food and energy declined from 2.5% last July to 1.7% in January.
However, higher-frequency readings and a closer look at other inflation indicators suggest a somewhat higher risk of deflation: On a six-month annualized basis, CPI core inflation has declined to 1%, nearly matching the lows last seen in spring 2003 and the record-lows (in the modern history of the data, which start in 1957) of the early 1960s. In addition, ‘pipeline’ price pressures are ebbing fast, with core intermediate goods prices falling at a record 13.2% annual rate in the past six months. This sub-index is often a good leading indicator of finished wholesale goods inflation. While that plunge so far merely reverses much of its leap in 2008, growing economic slack suggests that it will decline further.
Moreover, import prices are also decelerating, reversing the impetus to higher inflation from accelerating import quotes in 2008. While ‘pass-through’ from exchange rate changes has declined over the past two decades, the dollar’s appreciation over the past year should reverse some of the previous run-up in consumer and capital goods import prices, and those reductions are just starting to show up at ports and at the retail level. That’s more likely now as a severe global recession creates more slack in the US and global economies. Prices for consumer goods excluding autos accelerated to a 3% clip last summer; six months later, a rebounding dollar and weak demand have cut the pace to 1.5%, and outright declines seem likely.
In addition, the deceleration isn’t confined to goods-producing industries; prices for industry output at the wholesale level are decelerating in a variety of service industries. A composite that includes prices for financial services, leasing, consulting, recreation and repair businesses decelerated to -0.9% in January from 1% at the beginning of 2008. Further, the housing bust has created a glut of owner and rental properties, which will depress rents. Owners’ equivalent rent (one-third of core CPI) has decelerated to 2.2%, less than three-fifths of the level a year ago, and this deceleration likely will continue.
Finally, slack is increasing in the industrial and service economies: Measured by either industrial operating rates or harder-to-measure ‘output gaps’, the level of slack is moving to record lows. Both the change and the level matter. Other things equal, prices tend to accelerate when utilization rates are rising and decelerate when they fall. While there’s no threshold level of capacity utilization above which prices rise and below which they fall, rock-bottom operating rates tend to be associated with falling prices. Manufacturing operating rates have plummeted by more than 12 percentage points in the past 18 months to a record-low 68%. Likewise, the ‘output gap’ – the difference between actual and potential GDP – likely fell to between -5% and -6% in the first quarter, and further declines are coming in both. We estimate that, if our forecasts for factory output and GDP are on the mark, manufacturing operating rates could fall by another four points, and the output gap could widen to 7-8%.
Cross-currents abound in the inflation outlook, creating uncertainty – and opportunity: Ongoing weakness in economic activity threatens to open significantly more slack in the US and other economies, which will push inflation lower over the next several months. In contrast, aggressive policies could eventually – over the next few years – push it higher, and the sharp rebound in spot and distant-forward inflation breakevens reflects these concerns. Thus, inflation uncertainty has increased, at least in the near term, suggested by the increased variability in surveys of inflation expectations. This stepped-up variability hints that surveyed consumer expectations may overstate inflation concerns.
However, as Jim Caron and George Goncalves point out, market-based measures of inflation volatility have not shown a parallel increase, and thus have not richened to levels that would warrant selling it. Put differently, inflation swaptions never really cheapened significantly, so selling inflation volatility is difficult. Instead, Jim and George note that inflation insurance three months ago was cheap in the cash markets, with implied 5-year breakevens (BEIs) going below zero as investors sold TIPS. However, given the recent rise in TIPS inflation expectations, breakeven trades are no longer cheap. As a result, they suggest that investors who expect a move towards lower inflation should sell breakevens because in the near term CPI-based carry prospects will be less in the months ahead.
Source: Morgan Stanley, February 26, 2009.
*Richard Berner is a Managing Director, Co-Head of Global Economics and Chief US Economist at Morgan Stanley. He co-directs the firm’s forecasting and analysis of the global economy and financial markets and co-heads the Firm’s Strategy Forum.
Before joining Morgan Stanley in 1999, Dick was Executive Vice President and Chief Economist at Mellon Bank, and a member of Mellon’s Senior Management Committee. He also served for seven years on the research staff of the Federal Reserve in Washington.
Dick is a member of the Economic Advisory Panel of the Federal Reserve Bank of New York, a member of the Panel of Economic Advisers of the Congressional Budget Office, and a member of the Executive Committee and a Director at large of the National Bureau of Economic Research.
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