Deflation: Not Too Early To Worry

The latest data on Chinese inflation was out today, raising concerns on the state of China’s economy and sparking fears of impending deflation. Four points to consider from local press sources:

  • From the South China Morning Post: “On a yearly basis China’s PPI rose only 2.7% in November, the lowest reading in 2 two years, while China’s CPI in November rose 2.2% from a year earlier, the lowest in four months.”
  • After citing one local analyst that is worried about deflationary pressures building in the Chinese economy, SCMP adds “The return of deflationary risks, which often (sic) associated with a contraction in economic activities, provides fresh evidence that China’s US$12 trillion economy is heading into trouble…”
  • A deep dive into the data by Xinhua News shows that food and energy prices pulled CPI lower in December. At the same time, they note that CPI inflation has averaged 2.1% for all of 2017 versus a government target of 3.0%.

While global market narratives have largely centered on US/China trade worries, this data reminds us that deflation lurks in the wings. Even at this late stage in a worldwide economic expansion:

  • US headline CPI inflation is just 2.5% (October data), versus +5% in 2008 and +3% in 2000.
  • Eurozone inflation is currently 2.2%, versus +3-4% in 2008.
  • Inflation in Japan was just 1.0% in October, with core (less food) prices just 0.4% higher than last year.

All of this sent us back to the former Fed Chair Ben Bernanke’s famous speech “Deflation: Making Sure “It” Doesn’t Happen Here” where he began his summary by saying “Sustained deflation can be highly destructive to a modern economy and should be strongly resisted.” Much of what he proposed in that talk – purchases of government bonds, for example – eventually came to pass as central banks around the world sought to spur inflation after the Financial Crisis. Full speech here: https://www.federalreserve.gov/boarddocs/speeches/2002/20021121/

Even if global deflation is a still–distant market concern, it is worth considering the following:

  • The next recession in developed economies (perhaps caused by uncertainties over global trade) will see deflation worries come to the fore again. We are, after all, starting from a low inflation base this time around.
  • As we mentioned in the Markets section, US TIPS spreads have come in over the last month and now price in 1.7% inflation for the next 5 years and 1.9% over the next 10 years. Both are, of course, less than the Fed’s 2.0% target after trillions of dollars in bond buying and this year’s tax cuts.
  • Deflation is the enemy of financial leverage, since the latter requires fixed payments but the former constricts the cash flow of businesses and governments. China’s increasing use of debt since 2008 is well known, but the issue extends to US corporates as well. We are less worried about Treasuries, only because the Federal Reserve has a track record of buying those to combat deflationary pressures.

The upshot to all this: despite the best efforts of global policymakers, inflation never got a head of steam in the current economic expansion, and that is a bad setup for the next recession. If global growth continues to slow, price levels will likely decline with worldwide GDP. Markets may shrug off central banks using the QE playbook as a way to remedy falling prices since it was only modestly effective in this cycle. Combine that with markedly more financial leverage now, and the bounce back from the next economic downturn could be quite slow.