Deflation risk down but not out

While this week brought some pretty frightening numbers on industrial production and manufacturing surveys, I viewed Friday’s CPI release from the Bureau of Labor Statistics as slightly encouraging.

The BLS reported Friday that the seasonally adjusted consumer price index rose by 0.3% between December and January, implying a 3.4% annual inflation rate. For those of us who had been worried about deflation, that offers some reassurance that things may not be quite as desperate as we feared.

Month-to-month percent change (monthly rate) in seasonally adjusted headline CPI. Data source: FRED.

Some reassurance, I say, but not a whole lot. The January number still leaves the headline CPI down 2.2% from October, implying an annual deflation rate over the last three months of -8.7%. The year-over-year percent change in the seasonally unadjusted CPI has continued to drop, with the January 2008 to January 2009 change barely positive.

Year-over-year percent change (annual rate) in seasonally unadjusted headline CPI. Data source: FRED.

If we leave out food and energy, the January increase (+0.2% monthly) is enough to erase the deflationary signals for October and December.

Month-to-month percent change (monthly rate) in seasonally adjusted core CPI (excludes food and energy). Data source: FRED.

Even so, the year-over-year core inflation rate continues to decline through the latest reading:

Year-over-year percent change (annual rate) in seasonally unadjusted core CPI (excludes food and energy). Data source: FRED.

The gap between nominal Treasury securities and those whose coupon and principal are indexed to the headline CPI had vanished or even turned negative in November and December, perhaps reflecting significant deflationary concerns. That gap has since widened, suggesting bond-holders see deflation as less likely today than they did a few months ago.

Yield on constant-maturity 10-year U.S. Treasury bond minus yield on
10-Year 1-3/8% Treasury inflation-indexed note due 7/15/2018

Here’s why I think this is worth watching. There’s been some interesting discussion as to how we would objectively measure whether the stimulus plan will be beneficial. The core motivation for policy stimulus is the perceived need to increase aggregate nominal spending. Some have claimed that with the nominal T-bill rate near zero, monetary policy is no longer capable of providing such a stimulus. I disagree with that assessment, though I can understand that it is a very legitimate position to take. But if we do get back up to a year-over-year 3% inflation rate, I would think that an objective observer would want to agree at that point that we’ve achieved all we can hope for with the tool of demand stimulus. I continue to recommend that the Federal Reserve think of achieving that 3% inflation rate as their primary policy objective at the moment.

We’re not there yet.

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44 thoughts on “Deflation risk down but not out

  1. GK

    One interesting aspect of 21st-century economics is the split of deflation into two types :
    1) The traditional Bad Deflation as seen in the GD.
    2) The Good Deflation on account of Moore’s Law, which only now is becoming large enough to start having economic significance.
    Semis and storage combined are industries of $450B/year, or about 1% of world GDP. This 1% of world GDP always experiences a phenomenon where a dollar buys 60% more each year, thereby increasing a customer’s purchasing power, as measured in GB of RAM or TB of storage, each year.
    In simpler terms, a 42-inch plasma TV cost $8000 in 2003 but is $800 today. As sub-$300 laptops emerge, developing countries get major productivity boosts.
    Plus, this 1% is growing as a share of world GDP. in 1994, it was only 0.5% of world GDP. This also does not account for the fact that software, fiber optics, photovoltaics, and biotech experience this phenomenon to varying degrees as well.
    It will be interesting to see when this factor has larger significance. How about when it becomes 2% of world GDP? 4%?

  2. GK

    Deflation is only a problem if it becomes worse than -2%, on a YoY basis.
    Minor deflation of just -1% is insignificant. There is little difference between -1% and 1% inflation in just a year.

  3. e-veblen

    The January core CPI (ex food & energy) is a relatively noisy indicator as far as deflation monitoring is concerned. The reason is that we typically see the effects of excise tax increases (usually showing up in the “Other” category, cigarettes etc) coming into play at the start of the calendar year. My scan of the CPI details suggests that some of this contributed to the 0.2 percent increase in Jan core CPI.
    Strongly agree with your recommendation for the Fed.

  4. Robert Bell

    Are you concerned that the Fed’s balance sheet (according to CR a few days ago) has begun to grow again?
    Also, do you believe that the Fed will be able to unwind its recently acquired positions easily?

  5. wally

    Increased prices can come from closing of productive facilities and therefore decreasing supplies of finished products. Examples are easy to find in construction products, for example (lumber, drywall, cement).
    If price inflation comes as a result of such supply limitation it says nothing at all about effectiveness of stimulus. In fact, stimulus will clearly have not stimulated at all.

  6. calmo

    Housing crowding out other consumer appetites until recently, now suddenly spurred on by promises of rescue packages…decide to finish off the basement drywall…causing supply shortages?
    I don’t think so.
    Ok, and providing alternative nutrition (more beer) causing spikes in liquor prices?
    Let’s forget about in yo face deflating housing (which may not show up in the OER registry)…too dismal…and visit the auto shows to slap ourselves silly wrt deflation.
    I don’t know JDH, 3% inflation looks so dreamy to me.

  7. frank zhao

    For a 3% inflation to be achieved, it means we are already out of the recession. As a trader, my money is betting on S&P to 400 level or less and from demographic point of view, we will have 12 to 14 years reduced consumer spending.
    Any inflation is not sustainable.

  8. Get Rid of the Fed

    If you want 3% price inflation, could you please be more specific by what “monetary policy” means? Thanks!

  9. stunney

    It seems people are worried about the Fed expanding its balance sheet.
    The Fed can increase reserve requirements any time it wants.
    It can sell dollar assets and replace them with euro or yen or sterling or rouble assets.
    It can sell its gold holdings.
    It can not renew lending programs.
    It can raise the rate on its lending programs.
    What’s the problem?

  10. DickF

    Oil at this time in histroy is intimately linked with our economic health.
    The oil/dollar ratio when oil was near its peak was around 10:1. Currently it is around 25:1. The late Jude Wanniski used a 15:1 ratio as a rule of thumb. I do not disagree that circumstances will alter the ratio, but it appears that Jude’s rule of thumb is still close. But there are such things as lack of storage capacity that have changed the ratio, so we are in for a severe increase in the price of oil at even the hint of recovery.
    With gold at $1,000/oz Jude’s rule of thumb would move the price to $67/bbl almost double the current price. If the 10:1 ratio is closer to equilibrium we are talking oil back over $100/bbl a rise of 2 1/2 times its current price. I have friends that I respect who are saying the oil will very soon be at $200/bbl.
    If POG stays at $1,000 or rises higher there is no way oil will not explode on the upside and it is not rocket science to understand what that will do to any hopes of recovery from our current slump.

  11. JDH

    GK: A little deflation decreases the likelihood of loan repayment and a little inflation increases it. Modest deflation makes the necessary real wage adjustments in some industries more difficult and modest inflation makes them easier. Also, modest deflation is a clear signal that monetary stimulus has not been enough to help, so the Fed should do more.

    Robert Bell: Yes, I continue to be concerned about the way the Fed has managed its balance sheet and believe this has made it more difficult for the Fed to achieve what should be its primary objective at the moment.

    Frank Zhao and Get Rid of the Fed: Here’s my proposal for what the Fed should be doing.

    Stunney: The problem is that most of the assets that the Fed is currently holding are things it would not be willing or able to sell in the current environment. I hadn’t thought of selling their gold. It’s only carried on their books at $11 billion, but I think that’s at $42/ounce, so there’s a quarter trillion there at market prices. But remember the nature of the situation in which the Fed would need to contract its balance sheet quickly– a sudden surge in inflationary pressures and loss of confidence in the dollar. I don’t know that selling off the Fed’s gold would much help the psychology of that situation.

  12. me

    > implying a 3.4% annual inflation rate. For
    > those of us who had been worried about deflation
    I wish economics schools taught “thinking like ordinary people” somewhere.
    Look, it’s the _ratchet_ that impoverishes middle class people, not one side of the up-and-down, dammit.
    FIRST the deflation to make everything owed less supportable and cause losses.
    THAT makes all the interest rates on savings drop to nothing.
    THEN the inflation to make all the savings worth less and cause losses, while keeping the interest rates low.
    You think 3.4 percent is good news? Do you have any ordinary savings you hope to rely on?
    Combine the pea-under-the-shell game with the Ponzi scheme. Nobody knows where the money goes, you work and save and it makes no difference.

  13. GK

    I would like to see more economic study of the new ‘Good’ form of Moore’s Law deflation, alongside the traditional ‘Bad’ deflation as seen in the Great Depression.
    The ‘Good’ Deflation is an economic factor that is still small, but rising in impact (it is already 1% or more of world GDP). Large corporations have built successful business models around ‘Good’ Deflation (Intel, HP, Dell, Microsoft, etc.)

  14. GK

    But if oil prices rise, inflation rises, but disposable income drops, and thus the likelihood of loan repayment DECREASES. Consumer spending on other goods also falls.
    If oil stays cheap or even falls further, disposable income rises, and thus the likelihood of loan repayment INCREASES. Consumer spending on other goods also rises.
    So cheap oil, even if it caused a bit of deflation, is still better.
    Should we be wanting oil to rise or fall? People are saying too many contradictory things.

  15. GK

    Again, I wouldn’t take deflation seriously unless/until the YoY number dips to -2%. It is still about zero.

  16. calmo

    Well that does it: GK needs to write Ben a letter about the frivolity of deflation…those house prices, those auto prices, even the fuel that goes into them…all just a temporary dip; gather up those trillions mis-issued in haste and sit back with a cup of tea to welcome back the golden days of 3% inflation.

  17. GK

    There is still no YoY deflation in the CPI, as per the chart in the article.
    I have yet to see intelligence, rather than emotion, from you.

  18. dunnage

    Cement, lumber, drwall: Regardless of production, there is supply and lots of it. If it stays stacked for years, realize this is not the first time. Construction is cyclical: you build till there is too much and then you stop; go chap. 11 if needed and change your name from Joe to Frank while living on stashed cash till next go around. The builders with names you recognize have played the cycles forever and lived high on the hog while taking advantage of known markets.
    Oil: storage everywhere. US could buy forever. Tankers filled floating about. But what better storage than capping wells and leaving product in place safely and cheaply. You know this isn’t the first Peak Oil either; always a slightly different story and never a shortage of people and policies to blame. Yet reserves contunue to go up while we claim they are going down. We’ll either drown in the stuff or choke on the fumes.
    But a new favorite: Liquified Natural Gas — can’t sell stuff so it’s actually being shipped here for storage. We are virtually atop an ocean of natural gas yet import most of our gas from Canada. And now storing the liquified. Ten years ago oil was at $10.

  19. calmo

    The consumer price index could be what I’m missing alright, GK…but you could be blind, missing house prices.
    You figure this compiled stat is a good gauge of deflation…or just useful in providing a low estimate for those gov payouts that need a modest figure for “Inflation Protected”?
    Consider what a disservice the OER is in representing housing costs, the major component of the CPI.
    During the boom, real inflation represented by housing prices was masked by OER, providing not only low inflation numbers but also fodder for Fed officials who took the opportunity to congratulate themselves on the Maestronics of their precious monetary policies.
    During the bust, the real deflation represented by falling house prices is misrepresented by the same compiled OER. [Much of the inventory is over-sized, recreational/seasonal and/or vacant –forcing owners to actually pay for “house sitters”: a negative rent.] Never mind that people are walking away from houses that are not worth what they paid for after years of mortgage payments, the compilation allows the official inflation to be respectable, manageable –divorced from reality.
    So GK, you can have the charts, I need real reports about substance.

  20. kharris

    Setting one month’s non-deflationary CPI reading against anticipation of a large, long-lasting output gap, I really don’t see why we should feel better. Single data points aren’t all that helpful. Is January the best month in which to rely on inflation readings, in any case?

  21. DickF

    In our current world price increases or decreases consist of two things: 1) a change in supply of a good or service relative to demand for the good or service, or 2) actual inflation, currency depreciation, or deflation, currency appreciation.
    As can be seen the words inflation and deflation are often misused to mean price changes for any reason. But consider, if a price increase is totally due to a depreciation in the monetary unit there is no real increase in wealth, no additional products are produced and no additional products are purchased. There is only money illusion.
    This is the problem we have when a contraction, what we are experiencing currently, is confused with actual deflation. A policy that leads us only to currency depreciation will do nothing to deal with the contraction and could actually make things worse as it confuses the price signals that businesses use to make business judgements.
    If you look at history, most recently the 1990s, you will see that the greatest periods of prosperity were during periods of greatest monetary stability. Increasing monetary instability is the wrong prescription.

  22. David Sky

    Sorry if I may be confused, but i do believe that deflation is supposed to be a decrease in the money supply.
    Price decreases are merely a symptom of deflation, as price increases are a mere symptom of inflation.
    How can the term inflation be used to mean both an increase in the money supply and an increase in prices? Even though the two things are correlated, they are not identical with each other. for example, it may take some time after the money supply as inflated for the price level to rise due to the debasement of currency.

  23. MikeR

    Good point David Sky. I have trouble with this issue myself. Not all currencty printing is inflationary due to changes in the velocity of money. It relates to the desire to hold cash for transactions or speculation.
    Some currency printing is good. Friedman might argue for a constant, 3% growth in the money supply by printing currency. In stable times, this might only result in inflation of 2%, so the remaining 1% is absorbed by an increase in currency demand and is like “free” money for the government.
    JDH, am I off track?

  24. kharris

    David S,
    Inflation is, by definition, a generalized increase in prices. Money growth is assumed to be the cause of inflation. Money growth is inflationary, but not inflation.
    There has been a substantial campaign to impose a new meaning on the term “inflation”, for reasons that escape me, but there are pretty regular efforts to impose new definitions on economic terms that are less useful than their original meaning, so it is not surprise that it is being tried with “inflation”.

  25. uber_snotling

    Let me echo calmo’s comment about the Owner’s Equivalent Rent (OER) distortion on the CPI metric.
    The year-over-year change in OER was +2.2%.
    The year-over-year change in the most recent 20-city Case-Shiller housing index was -18.2%.
    How can we possibly believe the CPI numbers for the last 5 years when they missed the enormous housing bubble and the current housing bust? The OER is the largest component of the CPI and it is pointing in the wrong direction relative to all other indices of housing prices!

  26. DickF

    The definition of inflation has become what you have stated it is, but the definition of inflation as a generalized increase in prices is actually the new definition growing from Keynesian aggregate economics. Prior to Keynes inflation meant a decrease in the exchange value of money and economists understood that it was distinct from price changes.
    The definition of inflation as a generalized increase in prices actually removes its monetary significance because it can mean a change in the exchange value of money, or scarcity of goods, or an incease in the money supply, or a change in velocity, or a change in demand for money, or a technological change, and many other things that might affect prices. If you do not know why prices have changed you actually know nothing.

  27. pat

    For people thinking housing index reflects inflation in shelter cost better than OER, I submit to you that a user-cost approach to calculate inflation in shelter cost right now is likely to give you an even HIGHER number of shelter inflation: user cost of shelter = (price at the beginnig of a month – price at the end of a month) + carry cost. As prices are generally falling, the term in the parenthesis will be positve, and the faster the house prices fall, the bigger this item is!

  28. pat

    Are you saying that at this stage, stagflation will be a better outcome than simple old-fashioned recession with inflation constant or slightly lower? What if the inflation is mainly due to higher oil prices, like gk(?) pointed out earlier? If so, I think the US government may be able to help in raising oil prices by increasing the strategic reserve of high grade oil and suggest the Chiese to do the same with their dollar reserves. But I am not sure I agree with this premise …

  29. JDH

    Pat: In my mind, the core question to ask at the moment is, how much can demand stimulus help? As long as we are facing deflation, more demand stimulus would be beneficial. As soon as we get back into an inflationary mode, then we know not to push further on the demand side, and also we know clearer how to control the demand side since we’d be back in the realm where conventional fed funds rate manipulation is effective.

    I am not saying that inflation will solve our problems. I am instead saying that as long as we have deflation, monetary policy is hurting rather than helping the situation. The Fed’s job at the moment is to be helpful, not hurtful, so using demand stimulus to stop the deflation should be the top priority.

  30. aaron

    I tend to agree with GK and DickF. It wasn’t just loose lending that caused problems, peoples disposable income dropped and expenses didn’t. That made debt riskier.
    A small increase in energy costs causes ripples and feedbacks that take a lot of time to work their way through the economy. I think higher oil prices eventually push prices up more than just the additional cost of oil. The slimmer margins for business and less disposable income for people mean greater risk and uncertainty.

    Here’s how things look in transit activity and fuel consumption.
    I believe the peak in transit activity, followed and decline in fuel economy are both symptoms and compounding factors in our economic slow down. I think the decline in fuel ecomomy is related to a much larger problem of decreased transit efficiency in general. I think we’ll find that average speeds are down and drive times are up. This really limits our economic potential.

  31. Mike Laird

    Why did the chicken cross the road?

    “We must first study the chickens in aggregate; once we understand the chicken industry, then we can explain the individual chicken’s conduct.”-JDH

    “The behavior of the chicken is socially embedded.” -Menzie Chen

    “To collect dispersed knowledge.”- Hayek

    “Because of its animal spirit.”- Keynes

    “For creative distraction.”- Schumpeter, before he learned English

    “It was a deviation from trend line.” -GK

    “It was looking for gold.” -DickF

  32. calmo

    Thanks for brightening our day, Mike…may I speak for the rest of us somewhat humorless nailbiters?
    And thanks for joining us, wordsmith and more, kharris…the “substantial campaign to impose a new meaning on the term ‘inflation’ has eluded me so far unless it is merely those who dare to disagree with my own personal edition…the rabble.
    Would you say this is an infraction:

    As long as we are facing deflation, more demand stimulus would be beneficial.

    I am past grumpy.
    Mike: another load of chicken crossings please.

  33. smg

    Should we take 3 percent as the target inflation rate literally? The asked yields on 10 and 30 year treasuries are currently 2.78 and 3.53 percent respectively. If the Fed does as you suggest, and it’s deemed credible,and even if the announced target rate is less than 3 percent, there will be some sizable losses (depending on term to maturity) in the Treasury market. Is this just a necessary evil? How much of a loss should we expect? $100 billion? $500 billion?

  34. John lee

    @Mike Laird:
    “The chicken was looking for a change” -Barrak Obama
    “Maybe reasons like suicide” -Paul Krugman
    “Its behavior has been predicted for a long time, I knew it coming” -Nouriel Roubini
    “It was looking for a stress test, but no stress at my GS club ” -Tim Geithner
    “I want to have 100 Million, as it was my chicken” -Richard Fuld
    ps. less than 12 months to the bottom.

  35. DickF

    Anohter consideration. Obama is taking a Tiger by the tail in Afghanistan. Unlike Iraq Afghanistan really is a quagmire.
    There are not WMDs, there is no central government tradition (only tribal), there are few natural resources, the country has virtually nothing except its position close to Pakistan. Unless we are planning to invade Pakistan it has virtually no strategic significance.
    Obama has taken this on because it was a political ploy. If he is not careful the ploy may catch him.

  36. JDH

    smg: Yes, unanticipated inflation would cause a transfer of wealth from creditors to debtors. However, it is not zero-sum insofar as the inflation serves also to mitigate some of the deadweight costs associated with bankruptcy and with output below potential.

  37. aaron

    DickF, I’m not sure Afghanistan is the quagmire you think it is (though it could become one if we focus on drugs or are sloppy in the way we operate). For one, your point on its strategic significance, not for and invasion but for general operations. Two, Taliban and aQ have returned so that it’s no longer the waste of time and resourses it would have been to be working there the past several years. And, Afghanistan has valuable mineral resources (gem stones), it’s just that it will take decades to get them online.

  38. aaron

    And don’t forget it’s other borders. Just like Iraq, it gives us better position for dealing with Iran. I’ve even read rumors that we’ve worked with/supported aQ operations in Iran through afghanistan.

  39. kharris

    The whole “if you don’t know why X happened, you no nothing” construction is just about as studid a thing as can be written. “If you don’t know why you are bleeding, you know nothing.” Uh, not true in that case. You know to attend to the bleeding. “If you don’t know why your car isn’t running, you know nothing.” Not true in this case. You know you need to find another way to get to work, call the garage and have them take a look, make no offers to pick up groceries for elderly neighbors and such.
    What you know, when you see a generalized rise in prices, is that inflation indexed benefits and instruments will reflect that higher pace of inflation. You can take the inflation rate into account when considering rolling over debt or investments.
    You also know to look at velocity, money growth, the output gap, changes in the exchange rate and the like. So, just to make sure you get it, Dick, your claim about knowing “nothing” is utterly wrong. Really. It is stupid in a way that only dogma can explain, because a single moment of thought would have shown you how wrong the statement is.
    In the “old days”, we didn’t have surveys to tell us whether there was a generalized rise in prices. We had anecdotes. We had fx rates. We had gold prices. We had data that you could get without surveys. Now, we have surveys that provide far more complete information. What stood in the place of knowledge about generalized price changes was what people thought about, in the “old days”, because that’s all they had to think about.
    I understand that calling features of modern economics that you don’t care for “keynesian” has a certain appeal, but it is irrelevant in this context. What matters is that we have more information now about price trends than we had in days of old. Pretending that money growth “is” inflation ignores that information. Ignoring information is appealing when that information is complex and difficult to grasp and comes in various flavors like PCE and CPI and core and all-items, but that complexity, once grasped, helps us avoid the wrong-headed notions of people who condemn anything they don’t like or can’t grasp “keynesian”.

  40. GK

    I thought I had seen the height of creating worries about nothing, until I saw this Afghanistan nonsense between DickF and aaron
    Claims :
    1) Afghanistan is a quagmire.
    How? US deaths there are still less than 12 a month. The money the US spends on Afghanistan is a fraction of what we spent on Iraq.
    2) Afghanistan has precious natural resources (gemstones).
    Wha..? Is the value of Afghani gemstones even 1/1000th that of Iraq’s oil (estimated at $30T)? Given the land area of Afghanistan (about the same as Texas), it probably has among the least resources of any similarly-sized country. You will find more in Manitoba than in Afghanistan.

  41. tommus

    Funny this thread should weave it’s way to Afghanistan.
    Our financial system would already be history if not for the drug money deposits in the large banks. Maybe a few hundred billion $$$ yearly. That’s a lot of CASH. The president is taking the necessary action to keep this opium money flowing into the right bank accounts.
    “Victory” in Afghanistan is something different than what we are conditioned to expect, but you’d think after U.S. adventures in Viet Nam and Central America we’d have caught on.
    Not to worry: When all this smack is dumped on our depressed city streets we will finally see the velocity of money start to rise.

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