James Bevan: deflation expectations

The major central banks are all committed to avoiding deflation with their ultra-easy monetary policies, seeking to boost their consumer price inflation rates to 2.0%.

Yet, they have not succeeded despite several years now of zero interest rates (and more recently negative interest rates) and quantitative easing with purchases of gilts in the UK, government bonds and mortgage-backed securities in the US, government bonds and, more recently, corporate bonds in Euroland, and almost everything in Japan.

Importantly, whilst the G7 central banks have achieved headline inflation in aggregate of just 0.6% year on year (yoy) through February, the core rate, excluding food and energy, increased 1.7%. The comparable measures for the OECD, comprising 34 advanced economies, rose 1.0% and 1.9%.

The US weighs heavily in these numbers, with the headline CPI up 0.9%yoy through March and the core index up 2.2%.

Furthermore, the Fed prefers to target the PCE deflator (personal consumption expenditures), which has been slower-rising than the CPI owing to a much smaller weight from fast-rising rents.It was up 1.0% and 1.7% during February on headline and core bases.

Meanwhile, Euroland’s CPI was unchanged in March, and up just 1.0% on a core basis and Japan’s CPI is available through February and rose just 0.3% overall and 0.8% excluding food, alcoholic beverages, and energy.

Friedman’s hyper rule

For many, it is extraordinary, given the amount of monetary stimulus, that inflation isn’t well above 2%.

If it had been (correctly) predicted that from the start of 2008 that the combined balance sheets of the Fed, European Central Bank (ECB), Bank of Japan (BOJ), and People’s Bank of China, measured in dollars, would have expanded 157% through March this year, the expectation would have been for hyperinflation, reflecting the received wisdom, as taught by Milton Friedman, that “inflation is always and everywhere a monetary phenomenon”.

Friedman was a monetarist macroeconomist but Keynesian economists also believe that monetary policy can be used to achieve full employment and that the trade-off will be higher inflation, as determined by the Phillips Curve.

We can make sense of the apparent incongruity of data and theory by noting that the theory is framed in a macroeconomic context and there are powerful, deflationary microeconomic forces at work that make even unconventional policy tools ineffective.

First, there is the challenge of what happens in periods of war and peace. One chart we use in trustee training is the progress of the US CPI since 1800, which reveals that inflationary periods have been associated with wartime conditions, such as the War of 1812, the Civil War, World War I, and World War II through the Cold War.

The restoration of peace has then been associated with outright deflation, i.e., falling prices after each of these wars – with one exception.

There has been no deflation since the end of the Cold War, though the CPI inflation rate has declined from 4.7%yoy during November 1989, when the Berlin Wall was toppled, to near zero today.

We know that during wartime, governments mobilise and divert resources, and global trade is disrupted, whereas in peacetime, resources are allocated more ‘efficiently’ to reflect market messages, and there is a freeing up of trade and dismantling of government controls.

The end of the Cold War in 1989 was the end of the biggest trade barrier of all time. It led to China joining the World Trade Organization during December 2001, but thus far central banks have succeeded in averting deflation with ultra-easy monetary policy, but not in achieving their 2% inflation target.

Barriers to entry

One observation that we can make about macroeconomics writ large is that there’s not much focus on markets, especially competitive ones, which tend to be very deflationary.

We can think classically about low barriers to entry during peacetime meaning that established, profitable producers face competition from those that hope to take profits and apply capital where decent profits appear to be up for grabs.

Hence the importance of capital discipline and so-called ‘moats’ as indicators of entities able to deliver sustainable decent returns.

Technology is a connected factor, and as a result of the IT revolution, entrepreneurs are able to disrupt business models in every industry with innovations that provide consumers with the best goods and services at the lowest prices.

For example Steve Jobs at Apple was the entrepreneurial capitalist who drove the personal-computing revolution by inventing operating systems that could run PCs, laptops, smartphones, and iPads.

All these devices have become increasingly affordable, compact, portable, and powerful thanks to the Cloud and other innovations.

In the US GDP accounts, the price deflator for IT capital equipment spending has fallen 79% since 1977, when Apple introduced the Apple II, their colour computer with expansion slots and floppy drive support.

Capital spending, in current dollars, on IT equipment, software, and R&D now accounts for over 40% of the total of such spending, vs. 23% back in 1977.

Technological innovations have had the most deflationary impact on consumer durable goods in the CPI measures of the seven developed countries that show this component along with the nondurables and services sub-indexes of the CPI.

In the US, the consumer durables CPI peaked at a record high during September 1996 and since then is down 16%. Over that same period, non-durables and services are up 47% and 69%, respectively.

Here’s the rundown on consumer durables CPIs among the seven countries reporting these data since the start of 2001: Japan (-43.0%), Switzerland (-26.2%), Taiwan (-22.5%), Sweden (-21.8%), UK (-15.1%), US (-13.6%), and Eurozone (-0.6%). All of these economies recorded increases in their overall CPIs over this period, led by gains in both non-durables and services, with the only exception being non-durables in Switzerland.

There’s not much central banks can (or should) do about technology-driven deflation in consumer durables industries, which have embraced automation and robotics.

They’ve boosted their productivity, while global competition has reduced their profit margins and the resultant deflation has benefited consumers and supported living standards.

No need for children

On the issues of productivity and living standards, evolving demographics are a big issue.

People are living longer and more comfortably in their old age but governments have increased deficits with higher spending on entitlements and healthcare, rather than more focus on investment in infrastructure.

There has also been a reduction in birth rates in many economies, and some

commentators have suggested that this is because people don’t see a need for children to look after them in old age when the state will provide.

These demographic trends can be deflationary, given that older people tend to consume less than younger people with children.

This is one explanation offered as to why there has been a strong secular correlation between the inflation rate in the US and the so-called Age Wave, which is the percent of the labour force that is 16 to 34 years old.

The Age Wave has fallen from a record 51.2% back in January 1981 to 35.6% currently. Over that same period, the CPI inflation rate has fallen from over 10% to under 2%.

Unconventional policy

Japan has been through the mill on deflation already and last Wednesday, the Bank of Japan’s Mr Kuroda, gave a speech at Columbia University titled “The battle against deflation – the evolution of monetary policy and Japan’s experience.”

The BoJ has led the other major central banks with zero interest rates, quantitative easing, and massive currency depreciation in an effort to stop deflation and revive inflation but he looks as if he may be celebrating too early when he said:

Fortunately, the end of deflation in Japan is in sight as a result of the bold monetary policy measures called ‘quantitative and qualitative monetary easing,’ or QQE for short, we launched three years ago. Today, I will discuss how Japan, as the ‘front runner’ of deflation, has fought against deflation and is overcoming it. While doing so, I will also explain the theoretical background to the evolution of what is called unconventional monetary policy.

Mr Kuroda observed that “the unconventional monetary policy measures taken by the Bank of Japan can stand comparison with those taken by other central banks, at least in terms of their breadth and variety”.

But he also conceded that “none of these monetary policy measures were sufficiently strong to overcome deflation.” On 29^th January Mr Kuroda expanded and extended his QE, and also introduced negative interest rates.

He said last week: “The Bank of Japan will achieve the price stability target of 2% for sure by making full use of ‘QQE with a Negative Interest Rate.’”

Actually, in an environment of strong global competitive forces, and evolving technologies and demographics, he may be disappointed. Evidence again that ‘quality growth’ looks to be a prudent focus for investors.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla

*CCLA is a supporter of Room151

Photo: Craig Murphy, Flickr.

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