Monday, November 24, 2008

The deflation is coming?

Starting today, I will be writing a weekly column in Hurriyet Daily News on global developments and their impact on Turkey. Since this is the first time, I had to deal with a couple of unexpected developments, like not being able to find a neat-looking picture (and hence the Sopranos-style look) and having to shorten the article due to a miscommunication with the editor on the space alloted to me. Anyway, I am pasting the uncut version (wow, that made me feel like Ridley Scott) below:

I will be sharing in this column my two cents on global developments and their effect on the Turkish economy every Monday. Based on conversations with market participants and fellow columnists, I have decided to try to predict the future as much as explain the past, which means that inevitably I will sometimes be wrong. Given the uncertain times we are in, I would like to state upstart that I should be deemed successful as long as I am right 51% of the time. If Mustafa Denizli gets so much, so should I. Having got that out of my system, I can now turn to more serious matters:

Deflation fears are growing by the day, whether you look at search trends at google or mention of the d-word in newspapers. While a smaller inflation print would be interpreted as a positive number as recent as a couple of months ago, deflation is now in the headlines, and I mean literally, if you just have a look at the cover pages of Thursday’s Wall Street Journal and Financial Times. So to whom does deflation owe its newly-acquired fame to? While there have been serious analyses pointing towards deflation as early as the spring, most deflation-mongers base their case on two pieces of data: Wednesday’s October US CPI release and the inflation expectations derived from Treasury inflation-indexed securities. It is useful to assess how useful a predictor of deflation each is.

With the CPI falling at its fastest pace on record and the core index achieving its first decline since 1982 in October, Wednesday’s release is anything but inflationary. In fact, when I look at the distribution of price changes of the individual components, I can see a broad-based downward pressure on retail prices. But trimming the components of the index from extreme outturns and doing a couple of forecasting exercises point to an inflation rate in the order of 0.5%-1.5% for next year. Note that I am not an incurable optimist; in fact, I am expecting another large fall in the US CPI in November, which would bring yearly inflation to around 2%. However, for negative inflation, we would need much more than that: Boston-based economist Rebecca Wilder notes that eight consecutive declines on the order of the October fall would be needed for annual inflation to fall before zero. So, while there are deflationary trends in the US economy, deflation itself is still far away on the horizon.

In fact, economic theory and history have taught us that deflation will not be a serious problem unless falling prices get embedded in the consumers’ and firms’ expectations. In this respect, the recent rise in yields on inflation-indexed and inflation-protected Treasury securities (TIPS) over nominal Treasuries of similar maturity (see graph below) is being interpreted as expectations of deflation. For starters, inflation-linked securities have an inflation-risk premium and a liquidity premium, making a comparison with nominal Treasuries tantamount to comparing apples and oranges or Fenerbahce and Besiktas (I am not disclosing who I think the rotten apple is). In fact, the Cleveland Fed used to provide TIPS-based expected inflation estimates that accounted for these biases, but they have discontinued the practice since end-October, noting that the extreme rush to liquidity is affecting the accuracy of the estimates. This is not to say that something weird is going on in US Treasuries. The best answer to the puzzle has (so far) been provided by (future) Nobel prize winner Robert Barro, who notes that nominal Treasuries might have a negative beta- unfortunately the short life-span of inflation indexed Treasuries makes testing his theory impossible.

Leaving the oddities of US fixed income market aside (I assure you that market has more rarities than the Amazon jungle nowadays, with corporate bonds trading more cheaply than credit default swaps and the like), for the deflation threat to materialize, market expectations of deflation are not really important. The relevant expectations are those of consumers and firms, and in that regard, the data looks much better: For example, Conference Board’s expected inflation over the next 12 months is still at a hefty 6.9%. While this measure almost always overshoots actual inflation by a wide margin, falling prices are still far away from expectations.

But the fact that expectations are tame today does not rule out that they could deteriorate rapidly because of the credit crunch. Such a deterioration could come, for example, by a rapid contraction in money supply, but that is unlikely to happen as long as the Fed keeps up revving at this speed. But with the Fed finally having confessed that quantitative easing is underway –after having confused me and many fellow economists on what exactly it had been doing-, money supply is likely to be an important, if not the most important, gauge of the effectiveness of monetary policy in the near future, especially as the Fed hits zero-lower-bound at policy rates.

So, I hope to have demonstrated that if Paul Revere were as much of a cry-baby as the deflation-mongers, no one would have believed him when the British did come, and he would not have his statue standing near the Old North Church in Boston. Of course, the key question for us in the periphery is what all this would mean for Turkey? I think I have made enough predictions for the day, so this is where I will pick up next time.

1 comment:

ferhan said...

Thank you Emre for a concise discussion on the rising deflation fears. I can see why people are too much concerned about deflation but I have hard time understanding the reasoning behind it. I would like to draw people's attention to current and expected policy actions. I believe this is actually a good starting point to motivate a discussion on deflation.

Numbers are important but government policy that will shape the future, therefore inflation dynamics, do also play a key role. New Keynesian approach to inflation dynamics practically disregards past behavior of inflation and put mere attention on future inflation in determining today's inflation. Central Banker's nowadays take this approach seriously. Policy devised at shaping expectations (with good communication skills backed by credible institutions, in this case the US Fed and the US Government) has already begun a cycle of expansionary policy.

The power of expansionary fiscal policy that is underway should not be neglected. Moreover, during Obama's recent speech, announcing his economic team, he reiterated that economic recovery is the priority of the new president and a fiscal stimulus package aimed at jolting the economy and creating new jobs will be one of the first things that the government will implement. I am sure this will have some impact on expectations.

On the 'independent' US Fed side, there is still room for expansionary monetary policy. Especially on the long-end of the yield curve (hopefully reserved as the last resort).