December 12, 2008
THE "D" RISK KEEPS RISING
Deflation with a capital "D" may still be a remote possibility, but it's getting tougher to dismiss the idea that deflation light is here.
Exhibit A is this morning's update on producer prices, which fell 2.2% last month. That's the fourth month running that wholesale prices turned south. We can debate exactly when, or if a deflationary climate has begun, but once it's clear to everyone that the big "D" has arrived it's probably too late to do much about it. Simply put, if there's any hope of slaying the deflation dragon, the opportunity is a pre-emptive one. But that leads us back to the question: Is deflation really here? Or is the ongoing price retreat only temporary?
One can argue that collapsing energy prices are the primary cause of the downdraft in wholesale prices. True enough. But energy prices won't keep falling forever. Indeed, crude oil has fallen sharply since the summer, when it set an all-time record of $147 a barrel in New York. In December, crude's been trading under $50. Yes, crude and other energy prices may go even lower, and that would keep downward pressure on general price indices. But aren't we close to the bottom of this downward spiral?
Perhaps, but not just yet. The warning signs of deflation are mounting, which suggests that pre-emptive action is still the prudent choice. The good news is that the Federal Reserve and central banks around the world recognize the threat and have begun reacting accordingly, i.e., administering higher doses of liquidity as an antidote to falling prices. The bad news is that the medicine isn't working, at least not yet. Perhaps all the previous stimulus will soon kick in and do the trick, but the evidence is still elusive. That suggests that even stronger measures may be needed, including fiscal stimulus.
Alas, the latest news on that front for the moment is discouraging. We're speaking of the proposed government bailout of General Motors, which appears dead in the water in the U.S. Senate. The argument for keeping GM from imploding is stronger these days, given the deflationary winds swirling about. It's unclear just how much deflationary suction a collapsing GM might generate, but whatever it is it's sure to be too much since there's a surplus of similarly negative winds blowing from other sources. That includes retail sales, which the government tells us fell again in November—down 1.8% from the previous month and off 7.4% from a year ago.
In normal times, the economy could absorb the fallout of GM and perhaps some other troubles. But these aren't normal times and there's more than a few deflationary events unfolding at once. As the overall downward pressure on prices mounts, so too does the risk that deflation light may metastasize into something more serious.
The risk associated with GM is all the greater now that conventional monetary tools are nearly out of ammunition. The effective Fed funds rate was a scant 0.11% yesterday. Recognizing that negative interest rates aren't a possibility, the game shifts to fiscal stimulus and unconventional monetary easing by the central bank.
But that opens a new can of worms since fiscal stimulus is subject to political risk, as the Senate's snub of the GM bailout reminds. Meanwhile, there's not a lot of precedent with unconventional monetary policy and so trying to juice the economy on this front amounts to an experiment running in real time. To be sure, the Federal Reserve will find some success with engaging in innovative tools and strategies. But it's debatable if such actions will suffice in keeping deflation at bay, assuming it's really a threat.
On a positive note, one could point to the fact that on a 12-month rolling basis, wholesale prices are still rising. But the trend can't be ignored. In August, the producer price index was advancing by a hefty 9.7% on a year-over-year basis. That's fallen rapidly every month since, down to a mere 0.2% rise in wholesale inflation in November from a year ago. The train is rolling and it's unlikely to stop any time soon. The only question is whether we let it roll on or do we try to derail it?
There are risks both ways, although from our perch we're more worried about letting deflation build a head of steam. It's too late to avoid risky decisions. That said, doing nothing looks like the much bigger risk.
Posted by jp at December 12, 2008 10:00 AM
Thanks for answering so many questions. Good work.
Posted by: Steve B at December 14, 2008 3:51 AM