Tuesday, December 8, 2009

No Deflation Ahead

A number of influential, and legitimate, voices- including the Fed Chairman and PIMCO- have been raised recently to the effect that they expect the pace of the U.S. economic recovery to be a very moderate one. Although, the term "moderate" is a qualitative one and is probably used by Bernanke and PIMCO having different numbers attached to it, most of those who subscribe to that view are also calling for inflation to continue drifting lower over the next year or two, with some actually raising the specter of deflation as a result (see also a previous post titled "PIMCO's Bet").

Given that inflation is a lagging indicator and there is a considerable amount of inertia associated with its behavior, anticipating a further downward drift in the pace of price increases over the next year (particularly in regards to core inflation) is reasonable; promoting the view though that deflation is a plausible risk in the context of an unfolding expansionary period begs some further explanation.

Irrespective of such diverse views on the price outlook however, a down-to-the-earth look at some key measures of inflation expectations reveals an entirely different view.

After collapsing in the fall of 2008, overwhelmed by pervasive fears of a banking system disaster and a major, depression-like, economic downturn, TIPS break-evens (the spread between nominal Treasury yields and the yield on Treasury inflation-protection securities, which implies the expected rate of inflation over the investment period) have been widening steadily since the beginning of the year. This reflects underlying expectations that the overall CPI is likely to be returning to its recent historical averages of about 2%-2.5%, in the years ahead. In fact, both the 5- and 10-year break-evens currently stand very close to their levels prior to the Lehman episode in September 2008 (see below).

5-year TIPS Break-evens

Source: Bloomberg

10-year TIPS Break-evens

Source: Bloomberg

Simply put, the restoration of these spreads to pre-crisis levels, reflects the belief that the worst of the banking crisis is behind us and that the economy is recovering at a sufficient pace (irrespective of what specific number, or additional qualitative adjective, is attached to it) to ensure the gradual return of inflation to trend. As one would have expected the implied rate of inflation expectations over the 5-year horizon is somewhat lower than the one over the 10-year horizon, as the weight of 2010 (when inflation should remain especially weak) is obviously greater in a 5-year period as opposed to a 10-year one.

Another, fairly closely watched but admittedly "soft", gauge of inflation expectations is the "5- to 10-year inflation expectations" component of the University of Michigan Consumer Sentiment Survey, which continues to hover around the 3% mark in recent months. This is somewhat higher than the anticipated rate of inflation reflected in the TIPS break-evens, which is to be expected, as consumers' perception of inflation is typically associated with a higher number than the one officially measured by the CPI. On that score, it is worth recognizing that even the "short-tern inflation expectations" component of the University of Michigan survey (representing a 1-year horizon) is also anchored just below 3%.

Somewhat unscientific as these consumer inflation expectations measures may be, they still corroborate the financial market's fairly more rigorous perceptions of the price outlook and they certainly betray no uneasiness over any prospect of deflation, which, at the margin, could make the latter a self-fulfilling prophecy of sorts.

Deflation, as a trend and not as a short-lived quirk of year-on-year comparison in the various price statistics, is a phenomenon very hard to come by and Japan is the only major industrialized country to have experienced it in recent history- largely as a result of a double meltdown in its stock markets and banking system in the 90s and a notoriously slow policy response to address it. But both of these two potentially extremely destabilizing dynamics seem to have been contained in the U.S. at the present and, as a result, have convincingly pushed the risk of deflation to the sidelines.

Further disinflation is a plausible outcome in the foreseeable future, but much to the likely disappointment of the merchants of doom, deflation is not.

Anthony Karydakis