Deflationary Spirals

 Deflationary Spirals

Both the European Central Bank and the New England Patriots are battling expectations of deflation.

  

Deflation.

By John Makin Jan. 23, 2015 | 10:10 a.m. EST + More

Here is the question: What do European Central Bank President Mario Draghi and New England Patriots Coach Bill Belichick have in common? Answer: Both are worried about deflationary spirals.
In prices, the dangerous unanchoring of inflation expectations accompanied by the emergence of actual deflation in a number of European countries has led to deflation headlines that have raised the risk of a deflation spiral. In football, the allegation that Belichick-sanctioned, spin-enhancing football deflation occurred during the Patriots’ AFC Championship victory last Sunday has produced deflation headlines in the sports pages. The former problem is far more threatening to the global economy than the latter problem. But until the Feb. 2 Super Bowl game is played, the football deflation spiral issue will receive more front page media attention.
Never mind the sports deflation story; it's comical and engaging, yet it will disappear from the headlines as soon as the Super Bowl is over. In sharp contrast, the financial market deflation story has legs. It has grown as an issue over the past six months, and with the 50 percent collapse in oil prices since late-2014, the much-vaunted stabilizing-inflation-expectations anchor broke down as talk of widespread deflation rose sharply.
[SEE: Political Cartoons on the Economy]
Up until a few months ago, deflation (actual falling prices) was viewed as a boring issue, confined largely to discussions among Keynesian economists. Phrases like “deflation is not a serious threat” and it “won’t spread because inflation expectations are well-anchored” were reminiscent of dismissals of the incipient crisis in mortgage-backed securities during 2006 and early 2007. This view was widely-held among mortgage market participants, including the Fed, until June 2007 when two Bear Stearns hedge funds specializing in mortgage-backed securities failed.
During 2014 and 2015, the same pattern emerged when deflation actually appeared in southern Europe, Japan and the goods sector of the U.S.. Simultaneously, inflation expectations dropped sharply (see figure below) starting in mid-2014 to a degree that made it impossible to argue that inflation expectations were well-anchored. The key to anchored inflation expectations broke down, and prices spiraled downward.
From a mean level over the past five years of around 2.5 percent, U.S. five-year forwards (or expected inflation five years from now, which, outside of financial crisis, is usually a stable magnitude in the U.S.) dropped sharply, by about one standard deviation, to 2.2 percent by late 2014. It fell by another 0.25 percent, or another standard deviation, to about 1.95 percent in the first few weeks of 2015.

Date from the Federal Reserve Bank of St. Louis

The comic relief provided by football’s deflation spiral mess will disappear after the next Sunday’s Super Bowl, but the dangerous drop in deflation may continue at a more rapid — spiraling — pace. The Fed’s determination to start raising interest rates coupled with the ECB’s ongoing under-reaction to its intensifying deflation problem mean that the financial markets’ deflation problems will intensify.
[SEE: 2014: The Year in Cartoons]
The Jan. 22 ECB announcement that it will purchase $60 billion euros per month for 18 months (a total of $1.2 trillion), impressive as it sounds, represents just a leisurely replacement of the cash it drained from the banks in 2013-2014. In addition, the low yield bonds it is buying are already close substitutes for cash and so will produce only small credit channel effects on the price of assets. As close to the zero-bound interest rate as Europe is indicates that effective quantitative easing must raise inflation expectations in the market for goods and services and induce direct substitution of goods for the newly injected cash from QE. There is, as yet, little evidence of this direct boost in purchases of goods and services in Europe, hence it is likely the "too little too late" moniker will characterize the latest ECB effort during coming weeks.
In light of the key role that a rise in inflation expectations plays in the efficacy of QE at the zero bound, Federal Reserve Chair Janet Yellen needs to take a hard look at the above chart and ask herself if it is still reasonable to assume that inflation expectations are well-anchored. Clearly they are not, and clearly they are not rising. As inflation expectations fall, the rising demand for cash and near-cash will render the Fed’s now passive QE strategy from neutral to contractionary status, especially given the Fed’s continued determination to start raising interest rates at mid-year.