The Waning Threat of Deflation versus Two Easy-Money Pieces

I swear I had to read the latest James C Cooper piece in BusinessWeek twice just to be sure what I was reading. So I thought about doing a comparison to various academics and their current surveys of economic conditions, one was Paul Krugman's latest piece. This would provide a look to see where consensus was and where it was not, so I could gauge which argument(s) I found to have a more solid foundation.

James, an alumnus from NC State where he received his bachelors and masters degree, shows that Personal Consumption Expenditures declined from a year ago by 0.5% or 0.0005. He attributes most of this to the drop in gasoline prices. Here is the table from the BEA release.

Click to enlarge

As you can read from the chart his argument is correct. The index declined 23.7% in the energy good/services subcategory in the same time period.

However, now we can contrast this with Mr. Krugman's, with a BA from Yale in Economics followed by a PHD in Economics from MIT, evidence. He looks at the similar indicator formed from the Consumer Price Index. It also has a total value and one excluding energy and food prices because of their noted volatility. However, in this version instead of removing food and energy totally, he chooses to trim the data, that is remove the most volatile price movements to get to a "core" price movement. Here is the chart.

Click to enlarge

Here we can see the quarterly data from the 1st and 2nd quarter plus the data from September. So you can see the total annualized CPI for the three periods, in order, are: 1.5%, 3.3% and 2.0%. However, if you trim out the volatile prices, depending on the amount trimmed you usually what is basically a horizontal asymptote and those are: 2.3%, 1.0% and 0.5%, a clear downward trend. In fact if you look at James's chart it shows the same information, that both core and the more volatile are in a downward trend. So we have to separate pieces of data that suggest inflation will not be a concern moving forward.



The title of the chart even states in full caps CORE INFLATION WILL CONTINUE TO DRIFT LOWER. So rationally you could think that Mr Cooper and Mr Krugman are on the same page. "This suggests that disinflation is proceeding rapidly. And a falling inflation rate, possibly even deflation, means that a zero interest rate is less expansionary than it seems."

James, however, entitles his piece The Waning Threat of Deflation?!?!

It seems to me and anyone looking at these charts that are provided as evidence that deflation is on its way.

James bases his assertion on a few observations: inventories may have been cut too deeply along with capital spending (investment) and payrolls. He argues that inventory restocking, the actual fall of capital stock which affects the denominator in capacity utilization therefore utilization rates could increase faster in a recovery, and the fact that 6% productivity is unsustainable, thus new employees will need to be added. I would argue that the latter is the most important in James's arsenal as Consumption provides 70% of GDP, however a person cannot be a consumer without a job.

Luckily, just this morning I was reading a post by James Hamilton, a PHD and Masters in Economics from UC-Berkley, about unemployment and inflation. He found that by running a model of two year average of inflation and inflation expectation he could arrive at a very high correlation. Here is his chart.
Click to enlarge

His chart shows that inflation is still falling off a cliff and until unemployment turns, not just the stemming of jobless claims but actual growth of jobs that inflation will continue to fall. From his words, "but the forecast of the model for the average inflation rate between 2009:Q4 and 2011:Q4 is -0.5%." Again reiterating that without jobs no growth of GDP is sustainable, thus no inflation.

Finally, there is my new favorite graph. Median Duration of Unemployment. That is to say unemployment is not a bad thing per se, there is a natural creative destruction as employees from a dying industry like paper sales move to a more dynamic industry like alternative energy or health care. Unemployment is bad however when the economy cannot quickly move applicable skill sets, like sales of paper to sales of solar panels. Both require knowledge of a product and industry so they should be quick substitutes but when the economy is not doing this task people stay unemployed for long bouts of time. This, of course, impinges on growth. Let us see what the current outlook looks like.



Highest ever since it has been tracked.

The Fed has to act as training wheels for the US economy. It must support and guide the economy into growth but even as growth resumes it must not remove it stimulus too soon or relapse will occur. I do not believe Bernanke will remove stimulus until unemployment falls below 7%.

So in conclusion, I am not certain what James's article is about at all. He states that inflation will allow the Fed leeway to raise rates but does not specify how inflation will be brought about except for plausible stories without an econometric model to show how inflation will be transmitted. Merely stating that an inventory build or utilization rate climbing by decreasing the stock of capital does not guarantee sustainable growth based on an organic recovery. One of the major lessons for Bernanke as a student of the Depression was that the removal of stimulus in 1936 and 1937 caused the economy to crash in 1938. Then again James was the chief economist of the American Forest and Paper Association.

Serial Drivel

I usually breeze through BusinessWeek in about 10 minutes, just trying to sense the flavor of what MSM is cooking. But this week I could not just bypass this article without adding a comment, or two, or three. So below is the article with my notes attached.

There's an old saying in economic forecasting: The consensus is always wrong. But which way? The average forecast of the 52 economists surveyed by Blue Chip Economic Indicators calls for growth in real gross domestic product of 2.7% over the next four quarters, with the annual rate in any single quarter no greater than 3%. This early in the recovery, it's tough to argue that the consensus is either too pessimistic or too optimistic, but one thing is clear. The herd does not think the past tendency of strong recoveries to follow deep recessions will hold true this time. For example, in the first year after the severe slumps in 1973-75 and 1981-82, real GDP grew 6.2% and 7.7%, respectively.

The herd. The author uses the word herd to generate an impression of herd behavior or herd thinking. Too caught up in being like everyone else to see what is really occurring. Fine.

The correlation between the depth of recessions and the strength of recoveries over the last nine business cycles is unmistakable. It relates to the extent of the cuts businesses make in output, payrolls, and inventories. It also reflects the amount of pent-up demand created as consumers and businesses postpone spending. Like a rubber band, the economy snaps back in proportion to how far it was pulled down, as consumers finally upgrade old laptops and buy new clothes, and businesses replace inventories and worn-out equipment.

As he does not posit which business cycles, I will just assume he is talking about NBER's marking of recessions. But why stop there, why not 10; why not the just the last few? Do the 9 really represent what has occurred in this cycle? How about we make a comparison of this cycle to what previously occurred to see if we can rely upon a snapback, v-shaped, pent-up demand recovery that he posits.

Look in the last chart you can see cash for clunkers. However, there is much more in the CFR's report. Suffice to say I am not completely convinced that we can rely on the data from the past 9 cycles to be representative of what has happened and what might happen next. But I will continue to read with open mind in hopes of being persuaded.

If the consensus is right, the economy's departure from past experience would be striking. Economist Robert J. Barbera at the research and trading firm ITG (ITG) notes that after each of the past nine recessions, deep or shallow, real GDP has never required more than three quarters to regain its peak level prior to the downturn. If GDP staged a full recovery over the next three quarters, the economy would grow at a 5.4% annual rate. Even stretched over four quarters, the pace would still be 4.1%.

Again you must accept the wisdom that this is a normal recession just like in 1990, 2001 1981, etc. to then follow the conclusion that growth will be even better than the forecasters median expectation.

The common argument is that the usual rebound effect will be limited by the aftershock of the financial crisis: Credit growth is plunging, because households need to unload debt and save more amid lost wealth and tight credit, limiting the business sector's response. However, that's no sure thing. Data on credit flows are not particularly useful for predicting the strength of a recovery, according to economists at Barclays Capital. They note that in the strong upturns of the 1970s and 1980s, consumer spending accelerated well before the upturn in consumer credit.

My counter-factuals would be: A)that in the 1970's and 1980s Baby Boomers were entering the workforce, and for each one who entered there were more behind him/her coming. Thus, staking your place was fine, you could "buy-the-dips." Now however, those same leaders will be leading the way into retirement. The first Boomers are 63 now and in their mind's eye have been targeting the good life once they hit the Social Security mark. Now however, they will have to either work longer or save more if they hope to maintain their lifestyle. B) Also while the analyst at Barclays argue that credit may not be the major concern, as businesses have hoarded cash to survive this liquidity and solvency crisis. What should be a concern is CapEx spending.

CapEx has been dropping sequentially and year on year. So where are these revenues to come from if no one is engaged in attempting to grow their top line? The companies have done well to keep their profits up by annihilating their variable costs (labor.) So still not quite convinced but there is still more to come.

Early in recoveries, the growth of household income is a more important impetus to spending than credit. As job losses fade, pay from wages and salaries, about 60% of aftertax income, will turn up, as it did in July for the first time in nine months. Also, a lot of spending is done by households and businesses that either don't need to borrow or have good credit quality.

Aha! He has seen the light, it is hiring that will bring everyone back into spending! Let's look at the latest jobs report to see how great the job situation is going, the one that will bring us to above trend growth over the next 9 months.

Wait, what is this. The BLS stating that they have overestimated how many jobs have been lost over the past 20 months. It is actually 824,000 worse, which adds an additional .6% to the already abysmal 9.83% U-3 unemployment. Though it can be said that unemployment is not per se a bad thing when it is short term. It is only when it is long term unemployment that indicates a major problem with the economy.

That is structural unemployment is the highest it has been in 40 years! I am sure this is just a normal recession so the snap back should be starting any moment now. I wonder if I should mention that there is large proportion of part time employees who will have their hours increased before a firm begins to re-hire which can be seen in the hours worked survey from the BLS as well.

The recovery's oomph will also turn on how much income households feel they need to put away to eliminate debt and restore nest eggs. A rising saving rate weighs heavily on the growth of consumer spending. However, with savings in the second quarter already at 5% of aftertax income, up from 1.2% in early 2008, the saving rate may be about as high as it needs to go to give households the cushion they want.

So since we have established that all the rehiring because of all the revenue opportunities that companies are witnessing, we can then posit that consumers will go back to their prolific ways in spending our way to success. No mention of that as an open economy and the world's reserve currency that national savings will equal investment plus net capital outflows. Since the US dollar is in fact the world's dollar and that countries must use it as a store of wealth and a medium of exchange, which, of course, keeps the savings rate in the US artificially low since domestic investment is funded by foreigners allowing us to borrow freely from them. However, it does not state why consumers after being wounded with a 14 trillion dollar loss of wealth would want to continue to live paycheck to paycheck instead of saving for a rainy day. Please continue...

Historically, saving behavior loosely tracks the ratio of household income to wealth. As that ratio rises, in this case because of plunging stock prices and home values, so does the savings rate. By the second quarter the ratio had risen to the levels of the early 1990s, when the saving rate was about 6%, close to where it is now. Moreover, households in the second quarter recovered $2 trillion of the $14 trillion in net worth lost during the recession, and rising stock and home prices imply another gain of about $2 trillion this quarter.

The author now describes how savings is calculated and then undermines his argument by stating that the saving rate in a seemingly artificial manner dropped because of the rebound in the stock market. So we should actually look at the flow of funds report to see if savings increased not by its proportion but actually cash on cash over the preceding quarter. Here is the latest data 1219.9 followed by last quarter 1311.4 and the quarter a year back 1425.9. Since the economy has shrunk the savings rate shot up despite lower numbers. Although it must be said to save you have to pay off your creditors first.

So far, the raft of surprisingly positive data in recent weeks supports the more upbeat recovery scenario. In particular, the index of leading indicators, a composite of 10 gauges that tends to foreshadow recessions and recoveries, has turned up sharply. Since March the index has grown at an 11.7% annual rate, the fastest five-month pace since the 1981-82 recession.

The ten components of the Leading Economic Index include:

1. Average weekly hours worked by manufacturing workers - negative
   
2. Average number of initial applications for unemployment insurance - negative
   
3. Amount of manufacturers' new orders for consumer goods and materials - negative
   
4. Amount of manufacterers' new orders for capital goods unrelated to defense - negative
   
5. Speed of delivery of new merchandise to vendors from suppliers - positive
   
6. Amount of new building permits for residential buildings - positive
   
7. The S&P 500 stock index - positive
   
8. Inflation-adjusted money supply (M2) - negative
   
9. Spread between long and short interest rates (i.e. the yield curve) - positive
   
10. Consumer expectations - positive

So the positives from the reports are that monetary policy has effectively lifted the spread and the stock market. This has caused consumers to feel a bit better that the economic situation is not getting worse but is stabilizing. The new building permits has risen from a depressed level because of the cash for houses government initiative. However, on the whole no one is hiring, no one is adding more hours to the work week, no one is ordering more capital to build revenues. Seems a bit like a two sided report, everything that the government can touch is being held up by it and the rest is just wishful thinking.

For now, none of this will change the minds of the more pessimistic forecasters. However, the historical pattern is on the side of the optimists.

We finally agree. The analysis is sloppy. He does try to convey that he weighed both arguments for pessimism and optimism but it is not at all as thorough as it should be. I would have felt much better if he tried to dig further into his bullish arguments by explaining what portion of the LEI that he felt gave the economy the best bet. Was it the stock market? If so than his logic circles in this manner: the LEI is going up because the stock market has gone up therefore the stock market is going to continue to go up because the LEI presages it. Huh?