Double-Dipping to Deflation

July 23, 2010

The deluge of economic data that has fallen short of market expectations has been
relentless in recent weeks. It is now quite certain that the U.S. economy suffered a
material slowdown in economic growth towards the end of the second quarter; the loss of
momentum heading into the year’s second half is of concern, given that the support
provided by fiscal stimulus and the inventory cycle is set to fade.
Reliable leading indicators of economic activity suggest that a double-dip recession is
virtually assured, but whether or not the economy actually registers negative growth in
upcoming quarters is beside the point – the fact remains that economic momentum is
unlikely to be sufficiently strong in the year ahead to reduce the disturbingly large output
gap, and with calls for fiscal austerity growing louder, the risk that the U.S. economy
slips into deflation continues to rise.
The sharp slowdown in the pace of economic activity has been confirmed by a consistent
flow of disappointing data releases. Consider just a few – the University of Michigan’s
index of consumer sentiment plunged almost ten points to the lowest level since last
August, and the magnitude of the drop has been matched just seven times in more than
thirty years; retail sales registered back-to-back declines month-on-month in May and
June, an atypical development during an economic expansion; the level of outstanding
consumer credit declined at an annualised rate of 4 ½ per cent during May, the largest
drop on record in absolute terms and the 15th decline in the last 16 months.
Data from the manufacturing sector also point to a significant slowdown in economic
activity. Factory output declined in May and recent surveys indicate that the loss of
economic momentum continued through June. The Empire State Manufacturing
Survey’s general business conditions index dropped 15 points and is too close to double-
dip territory for comfort; the same is true for the Philadelphia Federal Reserve Bank’s
business activity index.
The message from the regional surveys is corroborated by the NFIB’S latest survey of
small business economic trends, which shows that small business optimism declined last
month to its lowest level since last December, and remains firmly in recession territory;
the survey reveals that poor sales remains the sector’s biggest concern, as both prices and
volumes continue to disappoint.
The disappointing activity data coincides with inflation reports that suggest the economy
is edging ever closer to deflation. The Consumer Price Index (CPI) dropped for the third
consecutive month in June, a development that has occurred on just six previous
occasions since 1947. The core CPI excluding food and energy, did register a modest
increase, but a sizable advance in tobacco prices accounted for most of the rise, while the
year-on-year gain remained at a multi-decade low. The inflation news is disturbing since
it was accompanied by a month-on-month drop in average hourly earnings, itself a rare
occurrence, and is corroborated by a downward shift in market-implied long-term
inflation expectations.
The annual rate of inflation is well below the Federal Reserve’s long-term objective of
1.7 to 2.0 per cent, but the minutes from the monetary authority’s most recent policy
meeting reveal that the committee is not particularly concerned by the deflation risk.
Indeed, developing and testing instruments ‘to exit from the period of unusually
accommodative monetary policy,’ appeared to rank higher on their agenda.
The Fed should be worried however, as real final demand growth has averaged a subpar
annualised pace of just 1 ½ per cent in recent quarters, in spite of gargantuan fiscal
stimulus and near-zero interest rates, and could slow to just one per cent in the second
half of the year, in the absence of any further boost from inventory restocking and fiscal
stimulus. That level of growth will only intensify the deflationary pressure, as it implies
neither an improvement in an already underemployed labour market, nor a reduction in
surplus manufacturing capacity.
The traditional monetary policy mechanism is already proving ineffective, because of an
increase in the non-financial private sector’s precautionary money balances, and
reluctance on the part of a recuperating banking system to lend. A downshift in
economic activity could well lead to a further increase in the non-financial private
sector’s demand for money and a reduction in credit creation by the banks, which could
become self-perpetuating should the change in the price level fall below zero.
Meanwhile, the reduction in aggregate demand caused by an increase in the private
sector’s financial surplus could be exacerbated by the Administration’s futile attempts to
reduce the fiscal deficit. There is no dispute that the trajectory of U.S. public debt is on
an unsustainable path, but now is not the time for fiscal austerity.
An increasing private sector surplus, combined with a reduced fiscal deficit, means that
the economy would require a sizable increase in export demand from the world’s
emerging economies to stay above water. However, policymakers in the developing
world are already taking measures to cool their overheating economies, so increased
demand from the East is a remote possibility.
The world’s largest economy stands on the edge of a deflationary abyss, yet the
government is debating fiscal austerity, while the monetary authority is discussing exit
strategies from its accommodative policy stance. The risks of a policy mistake are
looming ever larger; the time for further fiscal and monetary stimulus is now.

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The views expressed are expressions of opinion only and should not be construed as
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