Arc of a Diver: Inflation Succumbs to Deflation

by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.
Updated December 15, 2008

Inflation is coming down rapidly.
Deleveraging-driven recessions are deflationary, not inflationary.
Supply of credit easing, but demand shows no sign of recovery.
Global recession = falling commodity prices = disinflationary.

In 2005, when I served on the President's Advisory Panel on Federal Tax Reform, I had the pleasure of meeting the late, great Milton Friedman. Having been an admirer and student of his work, it was one of the most memorable experiences of my career. I often dust off Friedman's best quotes, and have used them many times in my reports.

In keeping with this report's topic of inflation versus deflation, here's one to mull: "I think there is universal agreement within the economics profession that the decline—the sharp decline in the quantity of money played a very major role in producing the Great Depression."

At Friedman's 90th birthday party, current Federal Reserve Chairman Ben Bernanke had this to say on the subject: "Regarding the Great Depression, you're right. We [the Fed] did it. We're very sorry. But thanks to you, we won't do it again."

Still fretting inflation?
Frankly, I have been surprised by the number of questions we have been getting about the inflation risks associated with the various liquidity and stimulus plans coming from the Federal Reserve and Treasury Department. Am I concerned about inflation? Sort of. But, what I'm concerned about is the lack of inflation … or better put, my concern is more about deflation than inflation.

We're in a recession that began in December 2007. It's unlike any seen in the post-Depression era. Typically, recessions are caused by rising inflation, related aggressive Fed policy tightening and/or inventory cycles. This is a balance-sheet recession with deep roots in asset deflation and deleveraging, and is accompanied by careening global equity markets, falling commodity prices, stagnant wages and declining production. This is all disinflationary, if not deflationary.

Fed's balance sheet explosion not inflationary?
The risk, of course, is that keeping borrowing rates too low, and the liquidity spigots open for too long will bring inflation back with a bang. Indeed, Milton Friedman was always quick to remind us that "inflation is always and everywhere a monetary phenomenon." And, the Fed's balance sheet has swelled massively, as you can see in the chart below.

Fed's balance sheet goes parabolic
Chart: Fed's balance sheet goes parabolic

Chart: Fed's balance sheet goes parabolic

As of December 5, 2008. Source: FactSet.

You can lead a horse to the credit trough, but you can't make him drink
Under normal circumstances, an increase in dollars would elevate inflation risks, but this environment is anything but normal. The global credit crisis is rapidly slowing the circulation of dollars, which will offset the effects of an increase in global money supply. Put another way, the velocity of money is plunging.

Even if reliquified, are banks going to jump to lend aggressively again? Not likely. Are households and businesses going to line up to the credit trough aggressively? Not likely.

The simple force of a decline in credit will not only limit economic growth, but inflation, too. Indeed, as I suggested in my recent report on deleveraging, "A Transformational Era of Deleveraging," the government is stepping in as the spender of last resort, but as it represents a fraction of the weight in gross domestic product (GDP) relative to consumer spending, it's not likely to fuel inflation.

Yes, the growth rate in the monetary aggregates is accelerating, but this is neither a sufficient nor necessary condition for rising inflation. What also impacts inflation is the "money multiplier," or the ratio of M2 money supply to the monetary base. It shows whether the rise in bank reserves is spreading out into the broader economy. As you can see in the chart below, it has nose-dived recently and if it fails to accelerate after the normal lags, expect more action from the Fed.

Money multiplier crashes
Chart: Money multiplier crashes

As of December 5, 2008. Source: FactSet.

History shows that during major periods of deleveraging, the "velocity" of money ebbs and acts as an offset to the rise in money supply. That's exactly what happened in Japan during the deleveraging era of the 1990s. The money supply remained confined to banks' balance sheets as demand for credit remained weak. When bank and household balance sheets are shrinking simultaneously, it's deflationary, not inflationary.

Commodity price implosions certainly not inflationary
At the same time, the global recession is pushing down prices for raw materials, goods and services and creating deflationary rather than inflationary pressures. The fall in commodity prices has been nothing short of breathtaking, with October registering the largest one-month decline in history.

Commodities have come back down to earth
Chart: Commodities come back down to earth

Chart: Commodities come back down to earth

Orange-shaded areas represent recession periods. As of December 11, 2008. Source: FactSet.

As you can see in the chart below, it's not just oil. Weakening global economies have put tremendous pressure on raw materials' demand in a very short time, with even China now having an impact. In October, China's manufacturing Purchasing Managers' Index (PMI), which was just released, contracted by the most on record.

Nonenergy commodities sinking, too
Chart: Nonenergy commodities sink, too

Orange-shaded areas represent recession periods. As of December 5, 2008. Source: FactSet.

ISI's economics group has an inflation model that incorporates a number of inflationary metrics, including the dollar, money supply growth, utilization rates, rental inflation (the largest component of the consumer price index, or CPI), unit labor costs, and commodities. The trend in each input, except for money supply growth, is forecasting a disinflationary impact on the CPI in the next several quarters. Even if commodity prices were to flatten out in the near term, inflation is approaching (or will fall below) zero due to the sheer size of the elevated comparisons a mere five months ago.

Headline and core inflation set to recede
Chart: Headline and core inflation set to recede

Chart: Headline and core inflation set to recede

Orange-shaded areas represent recession periods. As of October 31, 2008. Source: FactSet.

Deflation is the real threat
It's the first time since the Great Depression that the two biggest components of household net worth—stocks and real estate—are falling simultaneously. Deflation in these assets, as well as others, can become self-perpetuating as consumers hold off on consumption in the hopes of better prices in the future, keeping downward pressure on demand.

The cycle can become vicious, as it was in the 1930s in the United States and in the 1990s in Japan. On the other hand, mild deflation is less damaging to the economy and the stock market. In fact, the best performance for the S&P 500 since inception has come when the United States has experienced mild deflation, as you can see in the chart below.

Stocks love mild deflation

Chart: Stocks love mild deflation

Red bars represent deflation and blue bars represent inflation. Parenthesis represents number of quarters included in each inflation segment. Dotted line shows average total return. March 31, 1926 through September 30, 2008. Source: The Leuthold Group.

We believe the aggressive stance of the Fed and the Treasury Department today should keep us in the mild deflation camp.

Borrowers particularly take it on the chin during deflationary cycles, and today's an exaggerated example. I have often highlighted the impact of deflation in housing on borrowing metrics with the "real mortgage rates" illustration, seen below.

Real mortgage rates pressuring borrowers
Chart: Real mortgage rates pressuring borrowers

Chart: Real mortgage rates pressuring borrowers

Represents 30-year fixed mortgage rate minus year-over-year % change in median sales price. Orange-shaded areas represent recession periods. As of October 31, 2008. Source: FactSet.

In general, deflation is onerous for borrowers because as asset prices fall, it raises the "real" cost of credit—the opposite of what monetary policy needs to do to combat falling demand. Using mortgages as an example, and as illustrated above, when you are subtracting a negative number (real estate price declines) from a positive number (30-year fixed mortgage rate), you get an elevated "real" reading.

Simply put: A home buyer will currently pay a 5.5% 30-year fixed rate to buy an asset that's depreciating at a double-digit rate, putting his actual "cost" of borrowing significantly higher. It begs the questions: Who wants to borrow money to buy a rapidly depreciating asset? Who wants to lend money to someone to buy a rapidly depreciating asset?

Untethered global central banks
Clearly, good news is lacking today. Although waning inflation is a bright spot, a deflationary spiral, were it to erupt, is no great shakes for the economy. But given that a few short months ago, the world was fretting a massive surge in inflation generally, driven by commodity prices specifically, an easing of those pressures is at least marginally welcome. It certainly frees up central banks globally to aggressively combat the growing economic crisis facing all of us and pave a path to recovery.

As always, if you have questions or need help, please contact your Schwab consultant. If you're not yet a Schwab client but would like to learn more, a Schwab consultant can help. Call 800-435-4000 to get started.

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Examples provided are for illustrative purposes only and are not intended to imply future results.

Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

(1208-4024)

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