Don’t discount deflation just yet

June 5, 2009

My colleague Felix has asked me to justify why I am still writing about the threat of deflation. So here we go….

Firstly, there is still a risk that the economic green shoots wither. The data has only started to look more positive over the past month. Such a short spree of strong figures should not be trusted. Investors in TIPS – the inflation-protected Treasuries – no longer seem to be too concerned about deflation. They might be wrong. We can start to breathe more easily only when we can observe a strong trend in the three month moving averages.

Until then, there are still plenty of worrying signs.  Increasing evidence of wage cuts is a particularly powerful indication that the economy is still extremely unhealthy. (Pay cuts are to the economy what a frozen interbank market is to the financial system.) It’s also the first time since the 1930s that we are seeing widespread nominal reductions in pay. Until this trend is over we cannot be certain that the deflationary threat has passed. Pay cuts could certainly undermine the revival by increasing the already considerable burden of debt payments. There are plenty of other banana skins that could trip up the recovery.

Thirdly, I agree with the Economist leader of May 7th. Given a choice between inflation and deflation, I would opt for the former. For a start there is the question of proximity. Despite the extreme measures taken by the Fed and White House, inflation is still a distant threat. Policy makers can afford to wait until the economy is back on its feet before launching a pre-emptive strike on inflation. (It might be about as successful as certain other pre-emptive strikes the US has attempted…)

Also, policy makers historically have a better track record of dealing with inflation than of combating deflation. There is no limit on how high interest rates can be raised to attack inflation. Deflation is much trickier. Central banks cannot cut rates below zero. The quantitative and credit easing policies they are adopting are still relatively unproven. They are certainly worth trying but may not work very well. For example, the Fed may end up chasing its tail when buying Treasuries. (Fears that they are monetizing the debt could cause private investors to sell, raising yields and forcing the Fed to buy more. As they buy more, private investors have even more cause for anxiety.)

It’s a bit too soon to say the deflation threat is over.

One comment

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“There is no limit on how high interest rates can be raised to attack inflation.”

Uhh… So what’s 15% interest on 15 trillion dollars? Where do we get the money to fight inflation when we are so far in debt and in recession? You can’t print, because that will only make it worse…

Your outlook couldn’t be more wrong…

Posted by Jack Mehoff | Report as abusive