Deflation should not be a serious concern for US investors

22 Sep 2010 by Jim Fickett.

It is not worth worrying about deflation in shaping one's portfolio. First, the historical record suggests that (1) high debt, as we have now, is a significant danger sign for inflation and (2) while financial crises tend to lower inflation, outright deflation is a very rare problem. The main counterexample is, of course, Japan. However the parallel with Japan breaks down on the basis of both culture and policy. Perhaps most importantly, our own policy makers are not only on the case, they are deeply biased towards inflationary policy. Investors should be using the current lack of inflation concern as an opportunity to move towards long-term protection from inflation.

For some time I've been concerned primarily about the long-term inflation threat, but was also keeping an eye on near-term deflation dangers. However several recent studies have clarified where the risks really lie, and I think it is now clear that deflation in the US is not a danger worth worrying about.

The historical record 1: debt and inflation

An historical perspective can shed light on three different aspects of our current situation. First, high and rising debt is definitely a danger sign for inflation

Carmen M. Reinhart and Kenneth S. Rogoff, in a 2008 study entitled, Growth in a Time of Debt showed that, over the full history of the United States, there was a strong correlation between the level of gross federal government debt and the level of inflation. In particular, when debt was above 90% of GDP, the average level of inflation was over 6%. Currently, the ratio of the total public debt outstanding to Nominal GDP is 92%; i.e. we are over the critical threshold and the debt is still rapidly rising.

The historical record 2: financial crises and inflation

In a 2010 paper entitled After the fall, Carmen M. Reinhart and Vincent R. Reinhart look at the aftermath of “the 1929 stock market crash, the 1973 oil shock, the 2007 U.S. subprime collapse and fifteen severe post-World War II financial crises.” In general, a financial crisis is disinflationary, but this result must be qualified.

1929 is in a class by itself. Looking at 21 economies in the 10 years preceding 1929, there was significant deflation at some times and places, as well as high inflation in other times and places. The same was true in the 10 years following 1929. So although it is often stated that the Great Depression resulted in deflation, it is not at all clear that deflation was more of a problem after the crash than before.

Looking at 10 other financial crises in various times and places, it is clear that low inflation was more common after the crisis than before, although in many cases there was high inflation both before and after the crisis. Actual deflation was very rare – never worse than -1%, and never occurring for a long period in the cases covered.

Purely empirically, then, the lesson from Reinhart and Reinhart seems to be that a financial crisis does tend to lower the inflation rate; but actual deflation is a rare event.

In the Sep 2010 Quarterly Review of the Bank for International Settlements, there is a study by Garry Tang and Christian Upper entitled Debt reduction after crises. They start with a widely used data set of 40 well-studied financial crises, eliminate cases lacking full data, those involving a centrally planned economy, and those exhibiting hyperinflation, and then limit the data set further to those cases where a credit boom preceded the crisis. Of the 18 remaining cases, price data are unavailable in two cases, deflation took place in one case (Japan), and in the remaining cases inflation played a significant role in reducing debt. The lesson from this study is that, where data is available, inflation is by far the more likely outcome.

All told, the historical record suggests that a financial crisis does tend, in and of itself, to lower inflation, but deflation per se is a rare threat.

The historical record 3: slack economy and inflation

The most common argument from those that worry about deflation is that excess capacity in industry, and high unemployment, will work towards price declines. In a recent IMF working paper, Still Minding the Gap — Inflation Dynamics during Episodes of Persistent Large Output Gaps, André Meier directly addresses this concern.

He considers “inflation dynamics during 25 historical episodes in advanced economies where output remained well below potential for an extended period.” Here is the key result, showing inflation at the beginning of the period of slow growth plotted against inflation at the end of the period. The dashed line shows where unchanged inflation would be:

The insight from this work is similar to that we gained from Reinhart and Reinhart, and from Tang and Upper: disinflation is likely; deflation is not. Meier concludes:

We find that such episodes generally brought about significant disinflation …

… disinflationary pressures within episodes have tended to taper off at very low inflation rates. …

It arguably takes a particularly harsh series of shocks to push economies into lasting deflation.

Thus from three different perspectives the historical record suggests low inflation now and high inflation later, but not deflation.

The parallel with Japan

Many who fear deflation point to Japan, and there are certain parallels. For example, the ability of a government to build up debt without sparking inflation depends on demand for sovereign bonds. And just as a strong culture of saving has provided a seemingly limitless domestic market for Japanese government bonds, so many factors, in particular the dominance of the dollar in world currency reserves, and the US trade deficit, have provided seemingly limitless demand for treasuries. But there are very important differences as well.

Edward Chancellor of GMO does a nice job of summarizing the key differences in a Financial Times article earlier this month.

  • Japan was extraordinarily slow to recognize the bad loans at banks, and to recapitalize the financial system. While some losses are still being hidden in the US, write-offs and recapitalizations have been very aggressive in comparison to Japan.
  • In Japan, a nation with a strong saving culture and an older population than the US, price stability was a political imperative. In the US a large fraction of the population has considerable debt and little savings, and would benefit from inflation. (Witness the relatively frequent calls from economists and the press for some inflation to reduce debt burdens.)
  • As a result of this political difference, Japan's central bank did not undertake quantitative easing until 10 years after the crisis began. Contrast this with the strong and rapid response of the Federal Reserve.

It is difficult to quantify, of course, just how close a parallel there is between the US and Japan. However given that deflation is, in fact, a very rare problem from an historical perspective, the parallel would have to be very close indeed to worry us. And, simply put, it just isn't.

Washington is deeply and pervasively biased towards inflation

American culture, law, and politics all favor debtors over savers. Witness the mortgage interest deduction versus the tax of phantom gains on inflation. Many recent comments from politicians make it clear that any means available will be taken to prevent deflation, including actions that greatly increase the risk of inflation later. In a recent article, Rich Toscano and John Simon of Pacific Capital Associates summarize the long-term case for inflation (see also Toscano's earlier post for charts showing just how different the US monetary response was from the much weaker and more delayed response in Japan). As part of the overall argument, they do an excellent job of explaining why government biases and actions imply a very low risk of deflation. One particularly important point is this:

the Fed is willing to use quantitative easing (“QE” – a fancy term for the direct creation of new money in order to buy assets) not just as a crisis measure but as an ongoing policy tool.

Indeed. Fed policy is key, so it is worth repeating Bernanke's stance. In a recent speech at the Jackson Hole economics conference, Bernanke said,

Falling into deflation is not a significant risk for the United States at this time, but that is true in part because the public understands that the Federal Reserve will be vigilant and proactive in addressing significant further disinflation.

And as to whether this determination is realistic, in widely quoted remarks delivered in 2002, Bernanke said

Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

[emphasis added]

Finally, this was very recently spelled out quite explicitly by the full Open Market Committee. In the latest FOMC statement, the committee said the following (with the words in bold added from the previous FOMC statement).

Measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability. With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to remain subdued for some time before rising to levels the Committee considers consistent with its mandate.

The Committee will continue to monitor the economic outlook and financial developments and is prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate.

So the current core inflation rate of 0.9% is explicitly too low, and the committee is inclined to action. This strongly suggests that further expansion of the money supply is coming before too long.

An aside on policy

I am not saying that policymakers should ignore the risk of deflation. Although I disagree with Bernanke on many levels, and feel that he is greatly underrating inflation risks, I have to say that if I were responsible for policy, I would take the deflation threat seriously. Here I am speaking as an investor, and it is partly because policymakers are taking the deflation threat seriously that I think investors can discount the possibility.

Bottom line for investing

From an historical perspective, we are probably in for low growth and low inflation for several years, but not deflation. That suggests an emphasis on income – dividend stocks and short duration, investment grade bonds – in the short to medium term, and inflation-proofing – foreign investments, dividend stocks, and commodities – for the long term.

History provides a suggested range of possible outcomes, and that range is fairly wide. We have also to take into account that the Federal Reserve has taken, and will likely further take, very aggressive, even unprecedented action. So take low inflation for several years as the base case, but keep in mind that at any time confidence in Treasuries could falter and it would be very difficult then to avoid inflation.

Long-duration bonds, at current low yields, are a leveraged bet on inflation staying very low (or even negative) for the life of the bond. Buying the current 10-year treasury, for example, is speculation, not investment, and buying the 30-year is very risky. True, as long as everyone is worried about deflation, you will do well. But that outlook could change rather suddenly.