The Great Debate

Dr Strangelove and the threat of deflation

Fear of deflation haunts investors and stalks the halls of the Federal Reserve in Washington.

But how bad are declining prices, and why have they become a problem? Should investors and the Fed stop worrying and learn to love deflation, at least at moderate levels?

For 70 years, deflation was a distant threat as policymakers and economists wrestled with the problem of taming high and persistent inflation rates instead. It started to become an issue in the 1990s when inflation dipped below 3 percent for the first time in three decades, sparking a debate about “optimal inflation rates” and how the Fed should define its price stability mandate.

Eventually a consensus emerged in favour of targeting a low but positive rate of inflation rather than either zero (absolute price stability) or declining prices (deflation). In the United States, the Fed has in practice defined price stability as an increase in non-food and energy prices somewhere between 1.5 and 2.25 percent per year.

Proponents cite “nominal rigidities” in wages and prices, interest rates and debt contracts as the reason to favour a non-zero rate of price rises. Inflation gives policymakers and businesses much needed flexibility to cut real wages, prices, interest rates and the debt burden when it is difficult to reduce them further in cash terms. Small amounts of inflation “oil the wheels” of the economy.

Fed can’t fix broken economy, politics

The Federal Reserve’s decision to move to a kind of quantitative neutrality is a tacit admission that it, or rather that the United States, is in a political bind that makes a bold response to a deteriorating economy difficult.

Despite reams of evidence that conditions are worsening — much of it cited in the statement the Fed made as it left rates on hold — the U.S. central bank made only a token gesture; announcing that as mortgage-related debt it holds on its balance sheet comes to term and is repaid it will replace it  with new, mostly long-term, Treasuries.

That keeps its quantitative easing policy essentially static, a strategy dubbed “quantitative neutrality” by Northern Trust economist Asha Bangalore.

Stocks, bonds and the earnings season dance

A look at company earnings implies it is a great time to be a corporation in America, but for investors a rising savings rate and the threat of deflation mean that, ugly and risky as they are, government bonds looks good in comparison to stocks.

So far it has been a pretty remarkable earning season in the U.S. Almost 80 percent of companies reporting have beaten analysts’ estimates and profits among the largest companies are up more than 40 percent on the same period last year.
Perhaps even more remarkably, companies are managing to trouser a record 10.2 cents in every dollar of revenue after operating costs, according to Standard & Poor’s.

That’s the rub – profitability growth is outpacing revenue growth, which has been 9.0 percent, implying that the gangbusters pace of profits is more due to cost cutting and efficiencies than a sustainable expansion in anyone’s business model.

‘Random refereeing’ of economy is not what’s stagnating it

Apparently, the U.S. economy is being held back by massive uncertainty over new regulation, future taxation and the deficit and how it will be handled, a state so frightening and confusing that investors won’t invest, businesses won’t hire and nervous consumers have taken to their beds.

That, at least, is the account of Dallas Federal Reserve President Richard Fisher, who, in a speech last week, blamed fear of the arbitrary exercise of power by those in government for slowing the economy and putting those who make, employ and spend in a “defensive crouch.”

“For some time now in internal discussions with my colleagues at the Fed, I have ascribed the economy’s slow growth pathology to what I call ‘random refereeing’ — the current predilection of government to rewrite the rules in the middle of the game of recovery,” Fisher told business leaders in San Antonio.

from The Great Debate (Commentary):

Commodities should be short-term investments

Commodity indices and exchange-traded products (ETPs) should be regarded as short- to medium-term investments rather than long-term strategies, as a quick glance at performance over the last 10 years shows.

Their value lies in providing simplicity and liquidity for retail investors and institutions such as pension funds, which do not want the complexity of managing futures positions with their daily margin adjustments and rollovers.

They also permit institutions and retail investors forbidden from investing in derivatives to gain exposure indirectly by repackaging derivatives as swap transactions or embedding them in structured notes, which resemble debt or equity securities.

High unemployment and the education deficit

graduation photo USE THISThe following is a guest post by Bruce Yandle, distinguished adjunct professor of economics with the Mercatus Center at George Mason University and dean emeritus of the College of Business & Behavioral Science at Clemson University. The opinions expressed here are his own.

Last month’s report on U.S. employment growth brought no cheer to job-seekers with a high school education.

In June 2010, the unemployment rate for adults 25 or older with a high school diploma was 10 percent. Whereas unemployment among college educated adults was 4.4 percent. (Overall unemployment was 9.5 percent.)

from MacroScope:

What are the risks to growth?

Mike Dicks, chief economist and blogger at Barclays Wealth, has identified what he sees as the three biggest problems facing the global economy, and conveniently found that they are linked with three separate regions.

First, there is the risk that U.S., t consumers won't increase spending. Dicks notes that the increase in U.S. consumption has been "extremely moderate" and far less than after previous recessions. His firm has lowered is U.S. GDP forecast for 2011 to 2.7 percent from a bit over 3 percent.

Next comes the euro zone. While the wealth manager is not looking for any immediate collapse in EMU, Dicks reckons that without the ability to devalue, Greece and other struggling countries won't see any great improvement in competitiveness. Germany, in the meantime, has sped up plans to cut its own deficit.  It leaves the Barclays Wealth's euro zone GDP forecast at just 1 percent for next year.

from The Great Debate UK:

EU stress tests: for banks or governments?

- Laurence Copeland is a professor of finance at Cardiff Business School. The opinions expressed are his own.-

Worries about Europe’s banking system go back at least to 2007, but whereas the U.S. (and UK) banks appear to have weathered the storm, there are fears that for European banks the worst may lie ahead.  Concerns centre on four areas.

First, there are obvious worries about Greece and the other small countries facing debt problems, notably Portugal and Ireland, where the local banks have lent heavily to their governments and in addition may need to make provision for a substantial build-up in the level of bad debts in their respective corporate sectors as their economies struggle through the recession.

In praise of default

Join us for a live chat today at 1 p.m. ET with James, who will be taking questions about his piece.

Call me a default-ista.

For a huge number of borrowers, be they U.S. homeowners or the sovereign nation of Greece, a default or radical rescheduling of debt might just be the best, most practicable option.

More to the point, default in many of these situations may be not just in the best interests of the debtor but of the economy as a whole.

Inflation or Deflation, why settle for just one?

If you are trying to decide whether to fret about inflation or deflation, don’t bother: you may just get both.

Yes, in the spirit of these austere times, it is a two for one offer; deflation comes first, followed by an almighty inflation after central banks press the “go nuclear” button on the quantitative easing machine.

It seems clear that, at least in the near term, the stars are aligned for deflation. Rather than lancing a massive debt bubble, policy-makers have added to it and the intense pressure to clean balance sheets has spread from corporations and households to nations.