Will Global Deflation Risk Pinch US Economic Growth?

The world needs more inflation and if it doesn’t get it–soon–the slow burn of disinflationary pressure may tip over into outright deflation. It’s another wake-up call for central banks, which is another way of saying that the blowback of the Great Recession is still with us. Back from the dead? In fact, D-risk was never stamped out entirely; rather, it was only tamed. But the virus of falling prices has found renewed strength, which means that the global economy needs another dose of anti-viral medication.

Some of this is self-inflicted. The European Central Bank in particular has been slow to react in recent years. The key question now: Will policymakers do the right thing?  Defining “right” varies, depending on the economy. For the Fed, delaying the first rate hike is appropriate. For the Eurozone, embracing a robust program of quantitative easing–buying bonds with newly printed money–is essential.

Only time will tell if central banks react appropriately. What’s clear is that if renewed momentum in deflation is allowed to fester, recession risk will rise. It’s already happening in Europe, where headline consumer inflation turned slightly negative last month on a year-over-year basis. Meanwhile, Switzerland’s ill-advised decision  yesterday to abandon the cap on its currency resulted in a surge in the franc vs. the euro, an increase that raises the odds that the country’s already low inflation rate will soon turn into outright deflation. In a sign of the times, even China–the world’s growth engine in recent years–suffers from a falling rate of inflation and softer growth these days.

If we focus on recent history, the US looks relatively immune, thanks to a stronger rate of growth lately–the strongest in the world, in fact, among the major economies. But with D risk on the rise elsewhere in the world, the road ahead is looking increasingly precarious for America’s macro trend.

The critical question from here on out: Is the recent improvement in US growth destined to stumble? A convincing answer, one way or the other, requires a few weeks at the least as we review incoming data. But if yesterday’s numbers are an indication, we may be struggling to find clarity for several months.

The latest economic news for the US was a mixed bag. On the dark side, jobless claims jumped to a four-year high while December’s producer-price inflation tumbled the most in three years, leaving the year-over-year rate rising at a slim 1.1%. On the bright side, Bloomberg’s Consumer Comfort Index, a measure of households’ outlook for the economy, rose to the highest level in nearly seven years in last week’s reading. In addition, two regional Fed banks—the New York Fed and Philly Fed–yesterday delivered moderately good news in terms of growth via business survey data.

Quite a lot of the disinflationary pressure of late is due to the bear market in energy prices, which raises the possibility that inflation will stabilize once the oil market finds a floor. The optimistic view is that the latest deflationary wave is transitory a la energy, which is suffering from excess supply. But the argument that it’s all about oil supply is looking weaker in the face of a broader decline in commodities–a slide that implies that demand is now weakening.

For the moment, however, it’s unclear how to interpret the latest figures in the US. Is the recent acceleration in growth living on borrowed time… again? That’s too harsh a view at this stage, although downsizing expectations is in order. The US trend has improved in recent months—payrolls in particular have posted stronger gains. But as the surprisingly weak December report on retail sales reminds, the positive momentum is still vulnerable to external shocks.

It’s likely that we’ll see a fair amount of the growth acceleration in late-2014 reverse course in this year’s first quarter. America’s economy has enough forward momentum to keep it out of the business cycle ditch for the near term, but risks from abroad now look set to keep the US on a lesser growth path than recently assumed.

“Global growth is still too low, too brittle, and too lopsided,” Christine Lagarde
managing director of the International Monetary Fund, said yesterday in a preview of next week’s release of the group’s new economic forecast. “Moreover, there are significant risks to the recovery,” including “a risk that the Euro Area and Japan could remain stuck in a world of low growth and low inflation for a prolonged period.” Emerging markets are also facing challenges as well, she advised, citing the “triple hit of a strengthening U.S dollar, higher global interest rates, and more volatile capital flows.”

A stronger dollar will have a significant impact on financial systems in emerging markets, because many banks and companies have increased their borrowing in dollars over the past five years. The oil price drop – and weaker commodity prices more generally – have added to these risks, with some countries such as Nigeria, Russia, and Venezuela facing huge currency pressures. Given the size of these economies, the recent developments could also have significant regional effects.

The first order of business is nipping the deflationary threat in the bud. Recent events don’t look encouraging on this front. The war isn’t lost, but at this late date central banks overall can’t afford to lose any more battles.