The Onset of Deflation

Has this writer gone completely bonkers? (Don't answer that!). Surely inflationary pressures are rising? Isn't the Federal Reserve embarked upon a crusade to get "ahead of the curve", heading off inflationary pressure? Isn't the Japanese central bank widely regarded as being poised to raise the Official Discount Rate from zero, its first active decision for five years? Isn't Eurozone activity showing signs of turning the corner and the region's Central Bank making increasingly hawkish noises about putting rates up? Will the Bank of England curtail its prospective base rate reductions?

Maybe the knee-jerk response to these questions is in the affirmative but to us, soaring vulture-like way above left field, the real long-term (and thus ultimately more pervasive issue) pertains not to inflationary pressure, but to a return of the financial market bogeyman, deflation! Long-sighted central bankers know this and whilst they won't admit it in public, it is the single most likely cause of their insomnia.

This Is Why

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Recently the writer attended the annual conference of Capital Economics, the highly regarded and well respected economic commentary outfit, led by the influential Mr Roger Bootle.

The essence of Mr Bootle's thesis was not "Why are global interest rates so low?" ostensibly the title of his presentation but more accurately, "Why are global interest rates so high!"

During the presentation delegates heard Mr Bootle voice his views regarding the US fiscal deficit, bond purchases by overseas (notably Far Eastern) institutions, rapid money supply growth, portfolio switching by professional investors, excess savings and perhaps most interestingly, deficient demand. Most of these issues have been covered in depth and at length by ourselves over the past twelve months and more. Rising equity markets have generally caused investors to turn their backs, barely suppressing a derisive snort. But still we plough on, convinced ever the more so that a continuation of the way things are will simply serve to make the ultimate denouement that much more painful when it arrives.

What was perhaps most interesting about Mr Bootle's presentation was his view of the gulf that exists between, on the one hand, rising global productive capacity and on the other, still deficient demand. His conclusion is that global bond yields are so low because the financial markets believe that short-term interest rates will have to be low for years to come. The reason that short rates have to be low is because of a persistent demand deficit over existing and potential productive capacity.

The origins of this demand deficit can be found, he suggests, in the Asian currency crisis of 1997/98, an event with more profound and long-lasting consequences than many financial market operators care to acknowledge. It also has its roots in the increasingly built-in aversion on the part of European and Japanese consumers to consume rather than save.

It can also be found in the truly remarkable reticence on the part of the corporate sector to invest for the future. A report in Wednesday 5th October's FT highlights that UK corporate profits are at a five-year high. The same report reveals that business investment grew by just 4.1% in the year to the second quarter, a fact that the writer continues to find staggering given the low cost of capital. The, admittedly somewhat backward looking, OECD expects business investment to grow by just 2% over 2005 and in the US to slow from 9% over 2004 to just 5.8% in 2005. Perhaps it is, as Mr Bootle fears, that senior management has been made cautious by the impact of the popping bubble at the end of the 1990s and the ensuing economic slowdown.

Perhaps too, the corporate sector is now in such a state of "Maoist" perpetual revolution, such a state of paranoid desire to cling on to hard-won market share and to repel borders at almost any cost, that the collective eye has been taken off the ball. Companies are achieving profit growth by making use of rebuilt balance sheets to acquire rival or complimentary businesses. Such a strategy may work in the near term, but most if not all, fear the icy gusts of winter as low cost producing China (and to a marginally lesser extent) India increase their presence in the global economic firmament.

Mr Bootle's conclusion is that global bond yields are low because market expectations are keeping them low. Market expectations are where they are because of the persistent (and widening) gulf between productive capacity and demand. In fact if things continue the way they are, then it will be rising real yields, not nominal yields, that might cause the financial markets pause for reflection (masterly understatement!).

Deflation

If you are the Chairman of the world's most powerful central bank you have to take particular care when waving red flags and talking about the risk of deflation. A literal description of a deflationary environment and all its consequences could cause panic and serve to exacerbate a situation which has, to our minds, a 30%-40% probability of taking place.

On the other hand, not talking about it is concerning to those people who understand the consequences of deflation because it leads them to fear that the Fed doesn't recognise the risk or have a plan for dealing with it were it to break out.

Mr Greenspan (and regional Fed governors) are deeply aware of their responsibilities and position within the US political framework. This is why, in previous utterances, they have referred simply to "deflation" because deflation (although suffering many definitions) is, at its most basic, just generally falling consumer prices. The Fed has never, to the writers' knowledge, articulated the connection between deflation and a severe economic contraction.

When the wings of deflation beat loudly on the window panes two or three years ago, Mr Greenspan went out of his way to play down its threat and to play up the preparedness of the Federal Reserve to fight it should it break out. Significantly, Mr Greenspan fell short of articulating, in detail, what the Fed might do if deflation broke out. Ultimately he never had to. But just because the threat went away then, doesn't mean that it has gone away for good.

Simply talking about deflation in the context of generally falling consumer prices goes nowhere near far enough in getting to the root of the issue, in just the same way as describing the prevailing economic environment as close to recession would be equally misleading.

The economic definition of a recession is a contraction in economic activity that can be managed by monetary policy and is reversed by central bank easing via lowering short-term interest rates. Interest rate cuts make debt easier to service, make the de facto cost of items bought on credit cheaper and create a positive wealth effect (by raising the capitalised value of income streams that are discounted at the lower interest rate).

The process we refer to occurs when nominal interest rates cannot fall (because they cannot drop below zero). But real interest rates rise. So debt service burdens cannot be relieved, so asset sales have to take place to generate cash and costs have to be cut to generate profits. In lieu of interest rate reductions, prices have to be cut to stimulate demand, so credit problems and deflation ensues.

All in all, good stuff from Roger Bootle who remains one of the most far-sighted and thoughtful commentators around. His new book "Money For Nothing" is probably a good read, but this writer wonders whether it goes far enough. Perhaps, like Mr Greenspan, Mr Bootle has become something of a creature of the establishment and must now pull his punches to avoid precipitating panic. As this note indicates, one can follow Mr Bootle's conclusions to the next level. As financial market operators it's as well to know where Cerberus lurks!

By Jeremy Batstone, Director of Private Client Research at Charles Stanley Equity Research