Economy braces for deflation

High inflation strikes fear into the hearts of many economists, but its polar opposite, deflation, can be a far scarier beast as it heralds a full-out decline in asset prices, which kill productivity and growth. It appears that prices in the U.S. have indeed shifted into reverse gear, likely leading to a period of deflationary pressure on the rest of the world.

Deflation would seem on the surface to be a good thing. Lower cost of living means things become more affordable, but with it comes a slowdown in productivity, eventually a decrease in wages and investment, and most likely a stagnant stock market. It was deflation that was a major factor in Japan’s “lost decade.”

Most notable are the comments of the Bank of Canada’s governor Mark Carney, who warned in a speech on Wednesday that despite strong fundamentals, Canada’s likely to see productivity and income decline.

“The global recession is deepening, with demand slowing sharply across all major regions in recent weeks. As a consequence, there have been further declines in the prices of many commodities and a deterioration in Canada’s terms of trade, which reduce Canadian incomes. The nature of the U.S. slowdown, with its acute weakness in the housing and auto sectors, is also particularly problematic for our exporters, Carney told the United Kingdom Trade of Commerce in London, England.

As a result, Carney hinted the BoC will likely be making further rate cuts in the near future.

“While domestic demand in Canada remains relatively healthy and the depreciation of the Canadian dollar will offset some of the declines in external demand, the risks to growth and inflation in Canada identified in the October Monetary Policy Report appear to have shifted to the downside,” he says. “Despite having already cut official interest rates in half over the past year and having a financial sector that is still functioning effectively, some further monetary stimulus will likely be required to achieve the inflation target over the medium term.”

In the U.S., which already has a federal rate at the very low 1%, asset prices continue to drop at near record levels. In fact, the consumer price index had its single largest drop in more than 60 years as it dropped more than 1% to 3.7%. In a report entitled Deflation: You ain’t seen nothing yet, Sheryl King and David A. Rosenberg, economists with Merrill Lynch, warned deflation in the U.S. could be just getting under way.

“We are just at the tip of the deflation prints, in our view, and the pipeline price indexes in today’s report furiously sound this warning. Both the core intermediate and core crude goods prices dropped significantly, by 1.7% month-over-month (m/m) and 17% m/m respectively, pulled down by the collapse in commodity prices in the past couple of months,” King and Rosenberg note.

Michael Gregory, senior economist and managing director for BMO Capital Markets, says the U.S economy could see core inflation — a significant contributor to determining wages amongst other things — have annualized declines over a three-month period for the first time in more than 45 years.

“During the past three months alone, core CPI inflation has run at just a 1.1% annual rate — which is the lowest level since 2003 — which, in turn, was a time when the Fed was worrying about deflation and then-Fed Governor Ben Bernanke was musing about monetary policy implementation at the zero-bound for interest rates,” he says in a commentary released on Wednesday. “History, it seems, has a funny way of repeating itself. Indeed, in the 61-year history of the CPI, there has been only one month (during the 1960-61 recession) that three-month annualized core inflation has been negative. With retailers cutting their prices sharply heading into the holiday shopping season, history could repeat itself here too.”

King and Rosenberg are not willing to make a call yet on whether deflation is “benign” as it ended up being in 2003, or if this time around, asset price decline will be have a much more drastic and corrosive effect on the U.S. economy..

“The difference between 2003 and now is that monetary and fiscal policies were working back then, and the U.S. economy was on the verge of a massive upturn,” they write. “A benign decline in prices amidst a sluggish but recovering economy would be unwelcome but tolerable. But the price slashing now underway as the consumer beats a hasty retreat could allow that corrosive deflationary spiral to take hold — something the Fed wants to avoid at all costs.”

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com