Goods Deflation Is Good

Why are the major central banks so paranoid about deflation? It’s probably because they are staffed (stuffed) with macroeconomists who associate deflation with depression. In their opinion, falling prices make it harder for debtors to service their debts. Widespread defaults on those debts could cause a financial crisis and a severe economic downturn. I believe their thinking is that simplistic.

Yet, perversely, the central banks have been responding to the risk of deflation with ultra-easy monetary policies in an effort to stimulate more debt-financed spending. It seems to be working in the US, though a significant portion of borrowing in recent years has been in the corporate bond market to finance stock buybacks. More recently, debt-financed M&A activity has picked up as well. Often, these deals are associated with cuts in payrolls.

On the other hand, debt is financing a US boom in multifamily housing construction and solid activity in commercial real estate. Mortgage-financed new and existing home sales also have continued to recover from the Great Recession. Auto loans are financing cyclical highs in auto sales.

US consumer price inflation measures excluding food and energy are closer to 2% than to zero. So the Fed is more relaxed about deflation and started raising interest rates again at the end of last year. However, Fed officials constantly and consistently say that the process of normalizing monetary policy will be very gradual.

In the Eurozone and Japan, both headline and core consumer inflation rates are close to zero, i.e., bordering on deflation. Ultra-easy money has failed to stimulate borrowing and demand in their economies. Both have been in growth recessions over the past few years. Since Q4-2010, real GDP is up 10.5% in the US but only 3.2% in the Eurozone and 2.7% in Japan.

The Chinese authorities don’t have a deflation problem as measured by their CPI. They do have one as measured by their PPI, which has been falling on a y/y basis for the past 51 months through May. They have been all too successful at pumping lots of credit through their banking system in the economy. Perversely, rather than fueling demand, much of it has financed more deflationary capacity expansion. China actually stands out as the one country where deflationary pressures may very well lead to lots of debt defaults and a severe downturn. However, easy money is exacerbating the problem rather than ameliorating it. Let’s dive into the widely feared sea of deflation and see what we can see:

(1) Durables deflation. There are seven countries that report the durable goods, nondurable goods, and services components of their CPIs. Here is what they’ve done since 1996:

Durables: US (-16.1%), Eurozone (-1.4), Japan (-50.1), Sweden (-31.1), Switzerland (-26.4), Taiwan (-28.9), and UK (-26.9).
Nondurables: US (51.1), Eurozone (37.1), Japan (9.1), Sweden (36.0), Switzerland (-13.7), Taiwan (51.0), and UK (37.7).
Services: US (73.7), Eurozone (48.3), Japan (5.8), Sweden (45.9), Switzerland (7.5), Taiwan (21.1), UK (96.3).

The pattern is obvious: There has been across-the-board deflation in durable goods, while nondurable goods and services have continued to inflate almost everywhere. The only difference recently (i.e., since mid-2014) is that energy prices have contributed deflationary pressures to the nondurable goods components. Durable goods deflation has been mostly good deflation, attributable to big gains in manufacturing productivity thanks to technological innovations. Weak demand hasn’t been the source of the deflation. On the contrary, durable goods deflation certainly has benefitted consumers around the world, lifting their purchasing power and standards of living.

(2) Inflating & deflating in the US. In the US, durable goods deflation has been widespread, though five of the remaining six countries have had more of it since 1996. The US has had the highest inflation in nondurable goods of the seven. It’s had the second-highest rate of services inflation.

Interestingly, the CPI inflation rate in the US has tended to exceed the PCED measure mostly because of their respective services components. In April, this component was up 2.7% in the CPI and 2.2% in the PCED. There has been a persistent gap between medical services in the CPI, currently up 3.1%, and in the PCED, up 1.3%. That’s because the former covers all out-of-pocket expenses, but does not include costs paid by government health care programs. The PCED covers both.

Furthermore, while rent inflation is measured identically in both the CPI and PCED, it has a much higher weight in the former (at 32%) than in the latter (at 15%). Rent has been among the categories with the highest (and rising) inflation rates during the current economic expansion.

(3) Yen devaluation fails to reflate. Among the most startling economic events since late 2012 has been the 38% depreciation of the yen through late 2015. The Japanese government implemented a stimulative program in 2013, widely known as “Abenomics,” that included massive QE by the BOJ. The aim clearly was to devalue the yen with the goal of ending deflation by boosting export volumes and import prices. It hasn’t worked. Exports did rebound for a short period, but during April were back down to the lowest pace since January 2014.

Inflation remains around zero. As shown above, Japan has had more durable goods deflation than other countries, and the least inflation in nondurables and services. In Japan’s case, weak demand certainly has contributed to overall deflationary pressures. Much of that can be attributed to the rapidly aging demographics of the country. There’s nothing the BOJ can do about that.

(4) Leak in ECB’s monetary pump. The ECB remains committed to providing more ultra-easy monetary policy to revive economic growth and inflation. Indeed, starting this month, the central bank will expand its QE program to include corporate bonds. Loans to the Eurozone’s private sector rose just 0.5% y/y through April, notwithstanding a 33% increase in the ECB’s balance sheet over this period and the introduction of negative interest rates on June 5, 2014. The problem may be that many borrowers borrowed too much during the previous decade’s boom, and don’t have the capacity to borrow more.

(5) Refinancing paradox. So why haven’t the historically low interest rates provided by the central banks revived growth and inflation? Too much accumulated debt stimulated by easy credit conditions in the past is weighing on demand. Aging demographics are also a drag on growth and inflation. Technological innovation is disruptive and inherently deflationary. Some deflation, especially in durable goods, should be welcomed as good inflation.

Most perverse is the likelihood that ultra-easy monetary policy has contributed to secular stagnation. It has allowed borrowers to refinance at lower rates. However, on balance, it seems that supply-side borrowers are benefitting more than demand-side borrowers. In other words, companies that might have been forced out of business or forced at least to reduce capacity continue to produce, hoping to sell to consumers who remain wary of borrowing more even at lower rates.

Of course, record-low interest rates may be forcing consumers to save more given the pathetic return on their assets. Furthermore, they have less income from their fixed-income portfolios to spend. This all adds up to persistent secular stagnation, with central banks continuing to provide easy monetary conditions in the hopes that their demand-side models will come back from the dead.

US Employment: Shortage of Jobs or Workers?

Payrolls rose just 38,000 during May, the weakest gain since September 2010, and the previous two months were revised downward by 59,000 collectively. However, something just doesn’t add up with these weak numbers. Consider the following:

(1) Record job openings. In March, total job openings rose to 5.76 million, nearly matching July 2015’s record high.

(2) Solid ADP payrolls. Private-sector payrolls as measured by ADP rose 173,000 during May, well above the measly gain of 25,000 reported by the Bureau of Labor Statistics. So far this year, the former is up 940,000 while the latter is up 699,000.

(3) Confidence survey upbeat. In the Conference Board’s monthly survey of consumer confidence, the percentage of respondents who said jobs are plentiful remained around recent cyclical highs at 24.3%.

(4) Earned Income Proxy still rising. Our Earned Income Proxy for total wages and salaries in the private sector rose 0.3% m/m during May to a new record high. It reflects the tiny increase in private payrolls as well as the 0.2% increase in average hourly earnings; the average workweek was unchanged. The EIP is up solidly by 4.2% y/y. (See our YRI-EIP.)

(5) Troubling signs. I think that in the worst-case scenario, the latest payrolls suggest that there may be a big skills mismatch between all those unfilled jobs and the available workers to fill them. More likely is that May’s weak report is misleading, though we are disturbed by the downward revisions in the prior two months. The 12-month sum of those revisions remains positive, but barely so--which in the past has been a harbinger of trouble for the labor market.

Furthermore, in May the percentage of industries reporting higher payrolls fell to 51.3% on a one-month span and 53.2% on a three-month span. Both are the lowest since 2010. May’s non-manufacturing PMI fell from 55.7 during April to 52.9 last month partly because its employment component fell from 53.0 to 49.7, back down at February’s reading, which was the lowest reading since February 2014.

US Yield Curve: Global Yellow Light?

The spread between the 10-year US Treasury bond yield and the federal funds rate is one of the 10 components of the Index of Leading Economic Indicators compiled monthly by the Conference Board. There is no trend in this series, which tends to cycle around zero. It is widely deemed to be one of the more accurate business-cycle indicators, predicting economic growth when it is positive and a recession when it is negative. The spread does tend to lead the y/y growth cycle in the Index of Coincident Economic Indicators.

Of course, the spread is also available on a daily basis. A more sensitive version of this leading indicator is the spread between the 10-year Treasury yield and the 2-year Treasury yield. That’s because the latter tends to anticipate moves in the federal funds rate, which is managed by the Fed. Currently, the spread is still positive but narrowing. It was 96bps on Friday, May 20, down from the most recent cyclical high of 266bps during December 31, 2013.

Interestingly, the spread has been narrowing as the Fed has been moving toward normalizing monetary policy. When QE was terminated at the end of October 2014, the spread was 185bps. It was down to 128bps on December 16, 2015, when the Fed hiked the federal funds rate by 25bps. It was down to 93bps following the release on Wednesday, May 18, of April’s FOMC minutes, which heightened expectations of a rate hike at the June 14-15 meeting of the FOMC.

The FOMC is tightening monetary policy because Fed officials believe that the US economy is showing more signs of sustainable growth with inflation rising back near their 2% target. Yet the yield curve is warning that the Fed’s moves could slow the US economy and halt the desired upturn in the inflation rate. Another possibility is that while the US economy might be strong enough to tolerate the normalization of US monetary policy, the global economy is much more vulnerable to Fed tightening moves.

It’s a small world after all, and it seems that national economies and financial markets have become more interdependent than ever as a result of globalization. Fed officials are still operating as though the US economy is relatively independent of the rest of the world. Until recent FOMC minutes, overseas economic and financial developments were almost never mentioned in the minutes. Nor was the foreign-exchange value of the dollar. The US economy may still be relatively independent, but that’s not to say that other national economies and their financial markets aren’t more dependent on the US and on Fed policy than ever before. Consider the following:

(1) World business-cycle indicators. The yield curve spread is often shown on a chart as a leading indicator for the y/y growth in US industrial production, which is one of the four components of the US Index of Coincident Economic Indicators. Given the size and importance of the US economy, it isn’t surprising to see that the US yield spread sometimes has been a good leading indicator of the growth rates of both global industrial production and the volume of world exports. It may be increasingly so now thanks to the ongoing globalization of national economies and financial markets.

(2) S&P 500 revenues & earnings. It also isn’t surprising to see that the growth rate of S&P 500 revenues per share is highly correlated with the growth rates of world industrial production and the volume of global exports. Roughly half of S&P 500 revenues comes from abroad. The global economic slowdown over the past couple of years certainly has weighed on US company revenues, which have weakened further due to the strong dollar since late 2014. In turn, the weakness in revenues and earnings has undoubtedly weighed on US companies’ spending in the US and overseas.

The yield curve spread on a weekly basis has been highly correlated with the y/y growth rates in both the forward revenues and forward earnings of the S&P 500. The recent narrowing of the spread isn’t a good omen for either of them.

(3) Central banks’ policy divergence. All of the above suggests that the US yield curve may be a good leading indicator not only for the US economy but also increasingly the world economy. The Fed’s monetary normalization has pushed up the 2-year Treasury yield from a 2014 low of 0.34% on October 15 to 0.91% on May 23. This reflects the relative strength of the US economy, particularly compared to the weakness in the Eurozone and Japan, which has forced both the ECB and BOJ to double down on their ultra-easy monetary policies, with more QE and negative interest rates.

The result has been that global fixed-income investors have been buying more US bonds because their yields exceed those available in the Eurozone and Japan. In other words, the short end of the yield curve may reflect the relative strength of the US economy and Fed tightening, while the longer end reflects weak global economic activity and easing by the other major central banks.

The divergence between the tightening of the Fed’s monetary policy and the ultra-easy policies of the ECB and BOJ has certainly contributed to the strength in the dollar and weakness in both the euro and yen since mid-2014. However, so far, the latter have failed to boost exports in the Eurozone and Japan, while the strong dollar has weighed on US exports.

Could it be that while the US economy can handle a gradual normalization of monetary policy in the US, the rest of the world cannot do so? That may be the message conveyed by the US yield curve.

(4) Kuroda’s kabuki. Japan’s economy certainly remains fragile. The BOJ adopted negative interest-rate policy (NIRP) at the end of January. The Japanese 10-year government bond yield was -0.10% on May 23. Yet the yen is 15% above last year’s low on June 5. On May 23, we learned that Japan’s flash M-PMI fell for the fifth consecutive month in May to 47.6, the lowest since December 2012. We also learned that Japan’s exports (in yen) fell 9.5% y/y during April to the lowest since January 2014. Imports plummeted 20.0% to the lowest since December 2010!

(5) Draghi’s drag. The ECB first introduced NIRP on June 5, 2014. The German 10-year government bond yield was only 0.18% on May 23. Yet the Eurozone’s industrial production rose just 0.2% over the 12 months through March. Just as frustrating for the ECB is that the CPI inflation rate remains just below zero. It was just -0.2% y/y during April, according to the flash estimate, while the core rate was 0.7%.

US Entitlements: In Government We Trust

In addition to earned income, another important source of purchasing power for consumers is government benefits. We can see this by subtracting US federal government spending on goods and services as reported in nominal GDP from total federal government spending as reported by the US Treasury. The difference is federal government spending on income redistribution through the various entitlement programs. Here are some observations:

(1) GDP vs. benefits spending. Federal government spending on goods and services as measured in the nominal GDP accounts has been essentially flat around $1.25 trillion (at an annualized rate) since 2010. Government spending on benefits to persons was relatively flat at a record high of about $2.25 trillion from 2009-2013. Over the past two years, it has risen 11.9% to a record $2.50 trillion.

(2) Benefits prevailing. Federal government spending on income redistribution has soared from just 10% of total federal spending right before President Johnson’s Great Society programs were passed (1964-1965) to 67% currently. This percentage includes so-called tax expenditures like the Earned Income Tax Credit (EITC), which is a refundable tax credit for low- to moderate-income working individuals and couples, particularly those with children.

The EITC is included in an outlays category called “Income Security” along with the Supplemental Nutrition Assistance Program, Supplemental Security Income, unemployment compensation, family support and foster care, and child nutrition.

(3) Impact on shopping. Of course, not all of the government benefits are paid in cash to beneficiaries. Medicaid and Medicare expenses are paid directly by the government to health care providers. However, this frees up income received by beneficiaries either from earnings or from cash benefits such as Social Security to spend on goods and services other than health care.

The sum of federal government outlays on income redistribution and labor compensation (wages, salaries, and supplements) rose to a record $12.4 trillion (at an annual rate) during Q1. That’s up 4.5% y/y.

The sum of the cash (or near-cash) benefits paid by Social Security and Income Security programs plus labor compensation rose to a record $11.3 trillion during Q1, up 4.1% y/y.

In other words, consumers have lots of purchasing power provided by earned income and by federal government income redistribution programs.

Zhengnengliang

In the eternal battle between the forces of light and the forces of darkness, I prefer the light side. I tend to be an optimist. However, in recent years, my optimism has been focused on the outlook for the US. I’m less enthusiastic about the Eurozone and Japan. In general, I’m not a big fan of emerging economies, particularly China. As a result, I have recommended a “Stay Home” investment strategy as opposed to the “Go Global” alternative.

On the dark side, I’ve written often about the credit excesses that have fueled excess capacity in China, which has to be the world’s biggest bubble ever. I was early in detecting the country’s capital outflows problem. I would like the Chinese authorities to know that no one else at Yardeni Research has contributed to my critical analyses of the country. But I will continue to write the truth, the whole truth, and nothing but the truth, though it is becoming increasingly dangerous to do so, especially for economists in China. The 5/3 WSJ included an article titled “China Presses Economists to Brighten Their Outlooks.” It ominously reported the following:

Chinese authorities are training their sights on a new set of targets: economists, analysts and business reporters with gloomy views on the country’s economy. Securities regulators, media censors and other government officials have issued verbal warnings to commentators whose public remarks on the economy are out of step with the government’s upbeat statements, according to government officials and commentators with knowledge of the matter.

The stepped-up censorship, many inside and outside the ruling Communist Party say, represents an effort by China’s leadership to quell growing concerns about the country’s economic prospects as it experiences a prolonged slowdown in growth. As more citizens try to take money out of the country, officials say, regulators and censors are trying to foster an environment of what party officials have dubbed "zhengnengliang," or "positive energy."

China’s President Xi Jinping seems to long for the glory days of Chairman Mao. He launched an anti-corruption campaign in 2012. It increasingly seems aimed at vanquishing his foes and at consolidating his power. His latest campaign aims to galvanize China around threats to national security. In recent weeks, the government has called for vigilance against spies. Even in the schools, children are playing games such as “Spot the Spy.” In mid-April, there was the first-ever National Security Education Day. Volunteers in Beijing handed out thousands of umbrellas imprinted with a hotline for reporting any perceived risks.

The accuracy and credibility of Chinese economic data have never been very good. Now they could get much worse. The official M-PMI may be sent to the countryside for a reeducation campaign. It edged down from 50.2 during March to 50.1 during April. It may have to be shot, or at least disappear, if it drops below 50.0 this month. Another candidate for summary execution is China’s monthly series on railways freight traffic. The series, which isn’t adjusted for seasonality, rebounded in March, offsetting most of February’s drop; but its 12-month average is down 17% from its record high on January 2014 and the lowest since November 2009.

By the way, FRB-Dallas Fed President Kaplan should probably watch his back too. In a recent speech, he warned:

[W]e are closely watching China, given its size and importance to world GDP growth … We estimate that [China’s GDP] growth rate will slow to 6.5 percent in 2016 and likely trend lower in subsequent years. China is dealing with high levels of overcapacity (particularly in state-owned enterprises), high levels of debt and an aging workforce. In addition, it has embarked on [what is] likely to be a very difficult [economic] transition.

I have instructed my colleagues that in the event of my disappearance, they should carry on without me and write only upbeat stories about China.