Thursday, January 8, 2015

Awaiting the Horrors of Deflation

As we know, central bankers hate deflation.  They fear deflation almost more than they fear high rates of inflation.  Central bankers hate deflation because the spectre of falling prices means that consumers will postpone purchasing goods and services because they anticipate that the price of those goods and services will drop in the future.  With approximately 70 percent of GDP being composed of spending by consumers, if consumers delay their purchases, the economy will stop growing.

Japan has had a very lengthy period of deflation as shown on this chart:

If we focus on the period from 2001 to the present, this is what has happened to inflation:

Over more than a decade, Japan's inflation has averaged -0.19 percent.  As you will see later, there is a reason why I selected the year 2001.

Here is what has happened to Japan's Consumer Price Index since 1993:

Japan's consumer price index in October 2013 was roughly the same as it was in October 1993.  With the index set to 100 in 2010, a basket of goods and services that cost 100.7 in 1993, rose to 103.6 in October 2014 with nearly all of this increase taking place since March 2014.  

To help you put Japan's experience into context, here is what has happened to the Consumer Price Index in the United States since 1993:

Again, with the index set to 100 in 2010, a basket of goods and services that cost an American consumer 65.6 at the beginning of 1993 rose in price to 109 in the third quarter of 2014, an increase of 61.6 percent.  Now, that's what central bankers like; inflation!

What has happened in Japan since deflation began to rear its ugly head in the mid- to late-1990s?   In an effort to beat back deflation, the Bank of Japan (BOJ) began a program of quantitative easing (let's call it JQE1 to keep it distinct from the Federal Reserve's QE1) in March 2001.  Within two years, the monetary base had increased in size by nearly 60 percent.  JQE1 came to an end in March 2006 and the monetary base reversed its gains to some extent.  In October 2012, the BOJ began a second program of quantitative easing (JQE2) which saw the monetary base rise again.  When that program failed to cure deflation, the BOJ announced a third round of quantitative easing (JQE3) in April 2013 with the goal of bringing the monetary base yet again by the end of 2014 and the additional goal of raising inflation to 2 percent.  Currently, the monetary base sits at 2593603 one hundred million yen (yes, that's how the BOJ reports it), up from 1495975 one hundred million yen in April 2013 when JQE3 was announced, an increase of 73.4 percent in a year and a half.

Here is a graph showing the size of Japan's monetary base:

Here is a graphic showing the three rounds of QE (shaded in grey), the Consumer Price Index (in red) and the size of the monetary base (in green):

You can readily see that JQE1 was completely ineffective at raising the rate of inflation and, as shown on this graphic which shows anticipated inflation expectations over the 3-, 6- and 10-year framework against the rounds of JQE:

What we are seeing is that, while JQE2 may have had some impact on raising inflation, prices were rising before JQE2 began suggesting that inflationary pressures can increase with or without traditional central bank monetary policy intervention.

With this as background, let's look at what is happening in the U.S. economy.   A paper by Dr. Stephen Williamson, Vice President at the Federal Reserve Bank of St. Louis suggests (in rather arcane terminology) that the Federal Reserve's current policies are working against what it wants for the economy.  In his paper, "Scarce Collateral, the Term Premium and Quantitative Easing", the author suggests that the unconventional monetary policies adopted by the Federal Reserve since the Great Recession through the purchases of massive quantities of long-maturity government debt may be creating an unintended consequence - deflation.

Generally, QE is used when central banks would like to reduce short-term interest rates.  It does so by purchasing short-term government bonds.  In the environment since the Great Recession, short-term interest rates have been at or very close to the zero-bound (i.e. zero percent), so, purchasing additional short-term debt will have no impact on interest rates.  Central bankers have concluded that the mechanism that works for short-term interest rates will surely work further along the yield curve. This has led to the Federal Reserve adopting an unconventional monetary policy of purchasing long-term government debt to push long-term interest rates down.  

According to the author's analysis, conducting QE at the zero lower bound is different that conducting QE when short-term rates are well above zero, as they have been for most of our lifetimes.  By purchasing billions of dollars worth of long-term government bonds, the Federal Reserve is pulling down the "liquidity premium" on long government bonds (i.e sucking out less liquid assets and replacing them with relatively liquid assets).  His model implies that as the liquidity premium declines, inflation must also decline.  In other words, and avoiding the details of his analysis, the rate of inflation is primarily determined by the liquidity premium on government debt.

Here is a quote from Dr. Williamson:

"Some of the effects here are unconventional. While the decline in nominal bond yields looks like the monetary easing associated with an open market purchase, the reduction in real bond yields that comes with this is permanent, and the inflation rate declines permanently. Conventionally-studied channels for monetary easing typically work through temporary declines in real interest rates and increases in the inflation rate. What is going on here? The change in monetary policy that occurs here is a permanent increase in the size of the central bank's holdings of short-maturity government debt - in real terms - which must be financed by an increase in the real quantity of currency held by the public. To induce people to hold more currency, its return must rise, so the inflation rate must fall. In turn, this produces a negative Fisher effect on nominal bond yields, and real rates fall because of a decline in the quantity of eligible collateral outstanding, i.e. short maturity debt has been transferred from the private sector to the central bank."

Let's look at what has happened to personal consumption expenditures (annual percentage change) since the beginning of the Great Recession:

That certainly has a deflationary look to it, doesn't it?

Here is a final quote from Dr. Williamson:

"What I hope the discussion above makes clear is that this is a trap for the Fed. There is not much that the Fed can do on its own about the short supply of liquid assets. They can get some action from QE, but the matter is mostly out of their hands, and more QE actually pushes the Fed further from its inflation goal. If the Fed actually wants more inflation, the nominal interest rate on reserves will have to go up. Of course that will lead to some short-term negative effects because of money nonneutralities.

The Fed is stuck. It is committed to a future path for policy, and going back on that policy would require that people at the top absorb some new ideas, and maybe eat some crow. Not likely to happen. The observation of continued low, or falling, inflation will only confirm the Fed's belief that it is not doing enough, not committed to doing that for a long enough time, or not being convincing enough."

Looking at the example of Japan, the BOJ policies and the nation's intransigent deflation, it certainly looks like the Fed's policies since the beginning of the Great Recession may well have backed the world's most influential central bank into a deflationary corner.  The recent negative inflation rate in Europe provides additional proof that central bankers have been unable to foresee the negative impact of their six-year-long monetary experiment.

1 comment:

  1. Very interesting article, and it is hard to say how this will unfold. I feel bonds should be viewed as the Achilles heel of this low interest rate but inflationary period. The value of bonds is based on long-term predictions of government deficits and inflation.These forecast are often formed using assumptions based on rosy scenarios and politically skewed to benefit those in power. Like many investors I think the bond market is a bubble ready to pop and won't touch bonds with a ten foot pole. Knowing what we know about the effect that interest rates have on the value of bonds one might deduce that the 30 year bull run on bonds will have to come to an end the moment rates are expected to go up.

    To give you a sense of what this may mean to U.S. Treasury Bond investors a 10 year treasury bond issued at a 2.82% interest rate could see a 42% loss in value from a mere 3% rise in interest rates. This means if you hold $100,000 in these bonds after this 3% increase in rates, you would only be able to sell those bonds for $58,000 in the secondary market. Not only would bond holders be stripped of wealth if rates rise or even worse soar, but the higher rates would magnify the nations debt service and rapidly impact our deficit in a negative way. The article below explores just how big a problem this path could cause.