Consumer Price Index

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Deflation Risk?

Let’s not get too carried away with today’s consumer price report – the CPI fell 0.1% in April – but perhaps we should be more alert. Clearly the US economy is undergoing massive “disinflation”. The annual rate of inflation for the past twelve months was just 0.9%, the lowest since 1966. Prices fell across the board: autos, apparel, energy, and housing all declined and none show much likelihood of changing course any time soon. On the contrary the risk, and I mean risk, is that we could tip into deflation.

That would be bad. Very bad.

Deflation is something we have watched for and feared since the crisis began. It would confirm our decline into a Japanese style malaise, and would be very difficult to break out of.

The big problem deflationary economies have is that the steady drop in prices aggravates debt burdens. It means that debt is paid off in dollars whose purchasing power for goods is growing. Thus the foregone purchasing power needed to pay off the debt is also growing. In other words debtors get progressively worse off under deflation. Since we are knee deep in debt of various sorts that does not bode well for the economy as a whole. In fact the implication would be for a prolonged period of stagnation as debtors struggle to repay debts and have to forgo consumption in order to do so. Plus, of course, wages would be under downward pressure and thus add to the problem of debt repayment.

For an economy built around debt and consumption, as ours is, it is tough to imagine a more difficult prospect than prolonged deflation.

The good news in today’s report?

That any talk of inflation created by the burst of monetary expansion we saw in the emergency part of the crisis is obviously way premature. That talk was very popular earlier this year, especially amongst opponents of government spending. It was particularly an issue for the ‘born again’ fiscal conservatives within the Republican party as they sought to attack the stimulus and its after effects. I say ‘born again’ for the obvious reason that fiscal rectitude was not an issue for them back in 2001 and 2003 when the government’s revenues were slashed and the deficit problems that we now have were created.

So without an onset of inflation caused by the loose money and high government debt policies of the crisis management months, we can expect long term interest rates to remain static, or even float down as disinflation continues.

That all could be blown away by the backwash from the Euro crisis. But that’s another story.

For now we can say that fears of imminent inflation are misplaced. On the contrary we should be worried about deflation.

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Sales Edge Up; Inflation Flat

This morning’s news is a quiet confirmation that the economy is slowly perking up. But it is not a ringing endorsement of growth either. So we remain in a form of economic limbo waiting for stronger signals that the recovery is gathering pace.

The better news today is the March retail sales figure. Last week we heard a much heralded sequence of news form the big retailers all of whom reported good gains. Those numbers are always a bit misleading because they are not comprehensive, so we had to wait for today’s figures to see whether the big stores were an outlier or whether they captured an accurate picture of actual activity.

Apparently they were a fair indicator, even though they evidently they were stronger than sales as a whole.

The good news is that retail sales grew 1.6% in March, up from February’s 0.5%. The bad news is that sales of autos were a very substantial component of this total gain. If we back out autos the February number increases to 1.0% and the March number drops to 0.6%. So instead of a month to month increase we have a month to month decrease.

Wow. What to make of that?

Basically the message is unchanged. Activity is picking up, but very slowly. The recession is over, but it still doesn’t feel much like it. And risks abound.

Remember: one of the biggest features of this recovery will likely be a shift away from consumption towards investment and exports as drivers of growth. American consumers have been burned by the real estate bubble and will take time to rebalance their books. As they do that they will spend less and save more. All the signs support this view: consumer debt is dropping at a record pace as people shred credit cards and eliminate debt in order to free up cash flow. This is a healthy process but it will make the recovery much less vibrant. It is this adjustment that makes the current trends so difficult to get a good grip of. Anyone who makes bold claims about a strong recovery is underestimating the effects of the debt reduction process.

Another aspect of the slow recovery is the near total absence of inflation.

Once again the same mixed signals clutter the data.

The March CPI result is for a very low 0.1% increase. Negligible inflation in other words. This follows February’s 0.0%. But if we adjust for the items that tend to bound about – oil and so on – the figures are reversed. This ‘core’ CPI showed 0.0% in March down from 0.1% in February.

Inflation is just not an issue.

On the contrary we are perilously close to a deflationary trend.

Deflation would be a major problem: it makes debt burdens grow since future repayments are in deflated dollars. So an already debt heavy economy would be even more encumbered and households even more cash constrained than they are now. This is the trap that Japan fell into during the 1990’s from which it is still struggling to escape.

While I do not believe the US economy will drop into outright deflation, it is clearly undergoing a period of intense ‘disinflation’, which has a short term effect similar to that of deflation. I have advocated that the Federal Reserve Board stoke inflation a little in order to ensure we remain out of a deflationary zone. I think an annual inflation rate of around 2% would be very healthy. Not only would it keep us out of the hole japan fell into, but it would ease debt loads just enough to make real growth a more easily attained target.

The Fed does, indeed, target a ‘normal’ inflation rate of about 2%. Today’s numbers illustrate just how far away from that normality we are: the huge overhang of underutilized resources – most obviously that 9%+ unemployment rate – is pressing down on prices and making it practically impossible for businesses to raise prices. On the contrary, sluggish consumption is forcing a flurry of discounts and sales that push prices down. Hence the current absence of inflation.

Taking the sales and inflation figures together, we can characterize the economy as being in a slow motion and slightly positive trend. That’s good, but it could be so much better.

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Consumers Swoon; Inflation Flat; Weak Weekend

The flow of weak data continued this morning and leaves us all with plenty to ponder over the weekend: the economy may well be headed out of recession as inventories are adjusted, but beyond that the horizon is murky to say the least.

The theme all week has been the abrupt ebbing of forward momentum and today’s news that consumer confidence fell in July – the index dropped to 63.2 from 66.0 – merely reinforces a worrying trend. The consensus prediction among analysts had been that the index would rise to 69.0, so obviously plenty of people have been carried away by the hoopla over recovery rather than getting a solid read on the underlying factors affecting consumers.

Wall Street analysts are perennially optimistic and tend to see a bright future on the basis of the slightest break in the clouds. This is what has happened over the past two months. As all the data started to suggest that the economy was no longer in free fall Wall Street immediately rushed to the conclusion that it would adjust back to normal quite quickly. Hence the run up in stock prices that seem to be based upon profit projections unrelated to where business is today.

I would urge caution.

While it is very clear that the economy has started to level off and is no longer imploding at the rate it was last year, we remain very far from a sustainable recovery. On the contrary the turn around has all the makings of being a ‘technicality’ rather than a ‘reality’.

Consumers seem to agree.

Dark clouds are hanging heavily over consumers: unemployment is the leading issue, and there seems to be no prospect of job generation in the next few months. Home prices are devastated which has destroyed many people’s savings – home equity is a false measure of ‘savings’ but many families fell into the trap of believing it was secure. And even those who are still employed are facing shorter work weeks, lost benefits, and reduced wages. This is not a recipe for rapid recovery. Indeed it may not support recovery at all.

Prices reflect this weak activity.

The Consumer Price Index was flat month on month in July, which was about what everyone had expected. Food and energy prices fell sufficiently to offset increases elsewhere, especially in health care costs. Unfortunately the CPI has now fallen 2.1% since this time last year, which, while not unusual in a recession, is not a trend we want sustained for long: the threat of prolonged deflation is too damaging to be viewed without alarm.

The enormous slack in the economy provides businesses with no room for price increases; commodities are generally in good supply relative to the now low levels of demand and so their prices are not under great pressure; and labor costs are still falling. All of which suggests that prices will be quiescent for a while longer.

Overall I doubt inflation is a concern any time soon – until well into next year. This is despite the huge flood of money that the Fed has pumped into the economy over the past year. Most of that extra cash is now sitting as excess reserves held by banks at the Fed – it hasn’t found its way into the economy by way of credit growth. As long as that cash sits in the vault it represents no threat of inflation. But nor does it help us re-ignite growth. The Fed’s dilemma next year, or maybe in 2011, will be how to suck that cash out of the economy so as to prevent sudden uptick in prices.

You will read plenty of panicky stories in the financial press about the risk of inflation stemming from the enormously lax Fed monetary policies of the last year – pay them little or no heed. The people who are now worried about inflationary expectations driving up long term interest rates are ‘fiscal hawks’ – they are not focused on the depth to which the economy has plunged and the gap that has now opened up between actual activity and potential activity. My advice is to focus on that gap: until we have worked off the slack in the economy, that is until factories are humming, jobs are abundant, and workers are hard to find because they are all employed, inflation will be a theoretical rather than actual threat. Over a five year horizon I see rising inflation along with rising taxes to rein in fiscal deficits. Over the next two years though I don’t see inflation as much of an issue – not yet anyway.

So the week ends on a weak note. The optimists still cling to a vision of a recovery sufficiently robust that it self-sustains and thence accelerates. My view is that the recovery is less secure: until consumers are a firm footing with debts well covered, jobs safe, and wages growing, the economic engine will continue to sputter. As I reported yesterday: the entire GDP growth later this year can be attributed to the effects of the stimulus and an inventory correction. This means that the private sector is falling well short of the kinds of activity we need for a sustainable recovery to emerge.

This really does have all the makings of a jobless recoveryso we may well need more stimulus this fall.

The prospect for that is not good. Let’s hope that the next few weeks brings a turn about in consumer sentiment. Then we can look forward to 2010 with more optimism.

Addendum:

A brighter note:

Today’s release of real incomes shows a slight uptick in weekly wages from June to July. The growth came entirely from longer work hours as factories increased output to restore inventories. This is exactly the kind of impetus that the more optimistic analysts use when they forecast a self-sustaining recovery taking hold later this year. This evidence supports their case, let’s hope it continues.

More interesting in today’s report is the fact that wages increased 0.1% from July 2008 to July 2009. This looks very poor until we factor in the drop in CPI I mentioned above. Take the two together in order to arrive at inflation adjusted incomes, and real wages – which in theory are the measure we should be looking at – rose a decent 3.5% [ don’t add the CPI to the wage growth number: there is a separate CPI-W for wages, which deflated a little more than the overall number!] . This provides some extra hope that consumers will start to feel better about the future.

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