Temporary moderate deflation despite aggressive monetary expansion

Temporary moderate deflation despite aggressive monetary expansion

*Near-term declines in the general price level are expected to replace the recent low inflation and usher in a temporary period of moderate deflation, reflecting the collapse in aggregate demand and oil prices. We expect the core CPI and core PCE to fall to zero or slightly negative. These inflation trends will be associated with a significant deceleration of wage gains and squeezed corporate margins. The deflation of core goods and services will be sufficiently mild and temporary such that deflationary expectations will not become embedded in economic and financial behavior.

*This deflation will unfold despite the Federal Reserve’s aggressive, massive liquidity provisions and quantitative easing, and the government’s massive new deficit spending increases of roughly $2.8tn, or nearly 13% of GDP. As earlier described in “Critical economic issues related to COVID-19”, April 6, 2020, the Fed’s policies pose a clear inflation risk in future years, but the increased supply of high-powered money is not a sufficient condition for those risks to unfold.

*Inflation will resume only when economic activity recovers sufficiently to generate excessive aggregate demand relative to productive capacity. That requires that the Feds’ high-powered monetary base is put to work in the economy. The rebound of nominal GDP will be an important indicator of the risks of higher inflation.

Aggregate demand has collapsed in the face of COVID-19 and widespread government shutdowns. Nominal GDP, the broadest measure of current dollar spending in the economy, is expected to fall roughly 12% in the first half of 2020. While productive capacity has also been severely constrained by shutdowns, in general, the economy is dominated by insufficient aggregate demand for a broad array of goods and services. This is placing downward pressure on prices.

Accentuating the depth of the economic contraction, unprecedented loss of jobs and skyrocketing unemployment has abruptly shifted labor markets from being tight to slack. This will exert significant downward pressure on wage gains. Constraints on the supply of labor imposed by the government’s generous income support for those unemployed may partially mitigate the deceleration of wages.

The collapse in oil prices reflecting the sharp curtailment of global energy demand is leading to sizable declines in retail energy prices (“Macroeconomic impacts of the plunge in oil prices”, April 21, 2020). Reflecting these trends, a sharp fall in inflationary expectations sets the tone for price-setting behavior that will tilt price-setting behavior to the downside.

As a result, moderate inflation—the CPI rose 2.3% in the year ending December 2019 while the PCE price index rose 1.6%—is now expected to be followed by monthly declines. The headline CPI and PCE price index will incur outright declines exceeding 2% year over year while their core measures excluding food and energy will fall to 0% and maybe slightly negative. As a comparison, the headline CPI fell from 2.9% in 2007 to -2.1% in mid-2009, while the core CPI fell from 2.3% in 2007 to a trough of 0.6% in late 2010.

Certainly, prices of select goods in scarce supply, such as some basic personal necessities and food items, have risen rapidly, reflecting either soaring demand or distribution bottlenecks. While these price increases are receiving significant popular attention, prices of many consumer goods and services are falling, while others are less affected. Table 1 shows the major components of the CPI, their shares of the inflation index, price trends through December 2019, and our assessment of their expected trajectory resulting from the COVID-19 economic contraction.

Table 1. CPI Composition and Expected Changes in Trajectory of Prices

Sources: Bureau of Labor Statistics and Berenberg Capital Markets

Price increasers. Prices of medical care and food consumed at home are likely to rise from their recent trends, reflecting increases in demand, temporary shortages, and sizable increases in government subsidies to the health care industries. However, medical care expenditures are only 8.8% of the CPI and food consumed at home is only 7.6% (December 2019 shares), so they comprise only about one-sixth of the CPI.

Price decliners. Many large categories of goods and services in the CPI are expected to incur downward pressure on prices. These include housing, the biggest component of the CPI (42.1%), along with transportation (17.0%), recreation (5.8%), apparel (2.8%), and other goods and services (3.1%). Roughly 79% of the housing component is shelter—owner-occupied rent, rental value and lodging away from home. Following years of annualized growth exceeding 3% prior to the 2008-2009 financial crisis, this component flattened (its yr/yr change fell to zero) into the recovery. Rental values are now expected to fall. The remainder of the housing component is fuel and utilities, whose prices are now falling sharply, and household operations and furnishings, whose price index fell sharply in response to the financial crisis. Prices of apparel, recreation, and other goods and services, including a lot of personal services, are expected to soften.

Price trend unchanged. In the short run, prices of education (3.0%) and food consumed away from home (6.2%) are expected to be unchanged. Nominal spending in these categories is falling, but the trend in quality-adjusted prices is expected to be relatively unchanged.

Adding up the expected price changes in these categories and weighting them by their shares of the CPI points to a temporary decline in inflation and a deceleration of core inflation toward zero. The PCE price index has a lower share of shelter than the CPI and a higher share of health care services. Accordingly, while the year-over-year change in the PCE price index has been about 0.5 percentage points less than the CPI, we expect the inflation gap between these two measures to narrow.

Even after the acute stage of the pandemic ends and households and businesses begin to resume normal activities, insufficient demand and soft labor markets are expected to continue and price-setting behavior will put downward pressures on prices. This downward tilt will be reinforced by the sharp contraction in employment and aggregate hours worked and flatter wages sharply reducing real disposable incomes, along with the absence of inflationary expectations. This will be partially mitigated by the government’s enhanced unemployment insurance and income support programs, and declining energy prices.

Businesses will seek to jump start their revenues and cash flows through price discounts. A good example will be in leisure and hospitality, where demand will likely be slow to rebound. Bars, restaurants, and hotels will entice customers with attractive price cuts. Without cash flow, businesses will not survive, and they will accept lower margins. Cautious consumers will seek bargains on the goods and services they buy.

History shows that prices tend to lag trends in economic activity, and the residual impacts of the sharp contraction in aggregate demand are seemingly certain to last for a while. As shown in Chart 1, core inflation continued to recede for over a year into the recovery from the 2008-2009 financial crisis.

Chart 1:

Under what conditions will inflation resume?

The simple answer is excess demand relative to productive capacity is a necessary condition for inflation. While the Fed has poured a huge amount of money into the financial system—and therefore has planted the seeds for higher inflation—inflation will not reappear until that base money is put to work and generates a rebound in economic activity and excess aggregate demand. For now, the vast majority of the massive amounts of liquidity the Fed has infused into the financial system through its various asset purchase programs and business lending is sloshing around in financial markets and little is being put to work in the economy.

The Fed and the monetary policy channels. In summary, while the Fed has dramatically increased its balance sheet and the amount of base money in the financial system, the money multiplier—M2, a broader measure of money in the economy, divided by the monetary base (MB, bank reserves plus currency)—has shrunk. Chart 2 shows the spike in the Fed’s balance sheet, while Chart 3 shows the jump in M2. The recent spike in M2 (it jumped 11.0% yr/yr in March) reflected a sizable jump in bank deposits as risk-adverse businesses drew down their unused lines of credit from banks and left them as deposits in their accounts. At the same time, money velocity—the ratio of nominal GDP divided by M2—is falling, or, stated differently, the demand for money (cash) has increased, reflecting lower interest rates and risk adverse behavior by households and businesses. The declining money multiplier reflects to some extent bottlenecks in the bank intermediation process, while the decline in money velocity reflects the fact that the money in the financial system is not being put to work in the economy. The channels through which the Fed’s monetary policy affect the economy are complex, but for now suffice it to say that, for a variety of reasons, some of the channels are clogged and not operating smoothly.

Chart 2:

Chart 3:

The Fed has infused a dramatic amount of liquidity into short-term funding markets through its enlarged reverse-repo program and large purchases of commercial paper and short-dated municipal debt. These liquidity infusions were designed to avoid financial crisis as the surge in demand for cash and reticence to lend by financial institutions risked insufficient liquidity and contributed to dysfunction in financial markets. In addition, the Fed re-engaged in open-ended quantitative easing (QE) with massive purchases of longer-dated Treasuries, mortgage-backed securities (MBS), and created an investment vehicle to purchase investment-grade corporate bonds. The Fed is also directly lending to businesses in coordination with the Small Business Administration (SBA).

As a consequence of these programs, the Fed’s balance sheet has expanded more than $2tn to $6.5tn since the crisis began. Some of that increase reflects the Fed’s short-term funding that has replaced the funding normally provided by private institutional funders that faced impaired balance sheets and were reticent to lend. The Fed’s lending to businesses represents a direct infusion of money into the economy in the form of bridge loans. A sizable portion of the increase in the Fed’s balance sheet involves the Fed’s large-scale purchases of longer-dated assets that have increased excess reserves in the banking system.

But the impairment of bank balance sheets and capital has constrained the supply of credit banks are providing to businesses and households, except for the loans banks are making to small businesses through the Small Business Administration (SBA) loan programs set up in the CARES Act and subsequent legislation. Noteworthy, these SBA-sponsored bank loans add a layer of uncertainty to bankers’ lending decisions and likely constrain other lending to businesses. At the same time, the unprecedented spike in unemployment is leading banks to tighten consumer credit standards.

What are the risks?

In light of the uncertainties posed by COVID-19 and government shutdowns, there are risks on both sides of the deflation-inflation pendulum, and those risks will evolve over time.

In the near term, a downside risk involves persistent moderate deflation. This would stem from a continued decline in nominal GDP into the second half of the year and sustained dampened confidence. Sustained government shutdowns obviously keep a lid on economic activity, generate even more unemployment and declines in disposable income, and reinforce downward pressures on prices and expectations of deflation. The negative effects on confidence of a painfully slow reopening of the economy and ongoing concerns about health may overwhelm any pent-up demand and willingness to spend— by both households and businesses.

In the face of such risks, the Fed would face a very difficult challenge: how should it provide support to an economy that is incurring a sustained contraction when the source of the contraction is a pandemic and a health crisis way beyond the scope of monetary policy to fix? The logical answer is more QE, but that only boosts financial asset prices and encourages excessive risk-taking. Moreover, if the Fed’s LSAPs are extended to a broader array of financial assets, the role of government is expanded into the private sector in ways that may compromise the basic fabric economic system of the U.S.

The longer-term risk is a re-emergence of inflation to undesired levels. The massive initiatives of the Fed and the government’s deficit spending are unprecedented. Obviously, one way or another they must be paid for, and the current and future generations will bear the costs. The costs may take the form of higher taxes, lower provision of public services, slower potential economic growth that involves lower standards of living from what they would have been, a debased currency, higher inflation, or some combination. Let’s consider the risks of inflation.

The Fed’s aggressive increase in base money and the unprecedented spike in Federal deficit spending have sown the seeds for a significant rise in inflation. Government deficit spending has been increased by a total of $2.8tn, or roughly 13% of GDP. While the fiscal initiatives are primarily income support for the unemployed and bridge financing and grants to businesses, this deficit spending replaces lost private sector aggregate demand and will be the catalyst for stimulus that supports the economic recovery. The Fed’s monetary stimulus, which has boosted the stock market, along with lower prices of oil and commodities will stimulate a recovery in aggregate demand from its 12% decline. Meanwhile, the pickup in aggregate supply will be slowed by new constraints on production facilities and ongoing supply chain bottlenecks. Inflation will reappear as aggregate demand exceeds supply.

The Fed would welcome a return to inflation following a period of mild core deflation, and would tolerate it beyond the 2% target, in deference to the cumulative inflation shortfall in recent years. Could undesired inflation become a problem? Yes, if aggregate demand runs persistently ahead of supply, and if the Fed fails to normalize its policies and falls behind a rise in inflationary expectations. That seems unlikely in the near term, as inflation has historically lagged changes in nominal spending activity. The Fed’s aggressive balance sheet expansion and sustained zero interest rates in response to the financial crisis of 2008-2009 did not stimulate an acceleration in nominal GDP, so inflation remained muted.

But every episode is different. Current deficit spending policies and the Fed’s balance sheet expansion are significantly more aggressive than in 2009. Moreover, government intrusions into the economy are now elevated in magnitude and dimension, with unknown consequences, including its income support programs that will distort labor markets and wages if they are sustained. Accordingly, while any risks of inflation seem distant to the current challenges posed by the sharp economic contraction and fragile financial markets, they should not be ignored in strategic planning.

Mickey Levy, mickey.levy@berenberg-us.com

Member FINRA & SIPC
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