Is the current wave of risk aversion a speculative affair? No, not at all. There are fundamental drivers that are creating new headwinds for the economic recovery. At the core of the problem is the decline in inflation expectations. In a number of posts back in May we wondered if the then-nascent warning signs were simply noise. Three months later, it’s clear that the economy is struggling anew, and for reasons that won’t quickly fade.
At the leading edge of this struggle is the downward revision in pricing pressure. Inflation will likely remain low for the foreseeable future, a new IMF study suggests, based on analyzing 25 periods of “large output gaps” throughout the developed world going back to the 1970s. In other words, when an economy’s potential output is substantially higher than its current output, inflation is a dim threat for the near term. By most accounts, the U.S. economy’s potential output significantly exceeds current production. Expecting this to change soon is expecting too much. That’s not necessarily a recipe for disaster, but it’s almost certainly a large challenge to robust growth that won’t be resolved quickly. As such, the struggle and uncertainty of late will roll on for the rest of year and well into 2011.
That doesn’t stop some analysts from arguing that the Federal Reserve should raise interest rates. Perhaps the leading voice for tightening is Thomas Hoenig, president of the Federal Reserve Bank of Kansas City and a voting member on the Fed’s FOMC. Hoenig has been the lone dissenting vote on the FOMC for keeping Fed funds low. As Hoenig recently explained:
“In judging how we approach this recovery, it seems to me that we need to be careful not to repeat those policy patterns that followed the recessions of 1990-91 and 2001. If we again leave rates too low, too long, out of our uneasiness over the strength of the recovery and our intense desire to avoid recession at all costs, we are risking a repeat of past errors and the consequences they bring.”
But the market disagrees. The inflation outlook (based on the yield spread between the 10-year nominal and inflation-indexed Treasuries) fell to 1.68% last Friday (Aug 13). That’s the lowest since last summer. The market might be wrong, of course. Predictions are always risky because there’s the possibility that new information could change the outlook. But there are strong reasons for taking the market’s forecast seriously and expecting more of what’s been unfolding recently to continue in the months ahead.
Indeed, the underlying cause for the falling outlook on inflation is the slowdown in the economy. The smoking gun that’s first among equals is the continued sluggishness in the labor market. At the very least, it’s hard to argue that the trend in job creation is improving, as last week’s disappointing update on initial claims for new unemployment benefits suggests.
The weak labor market is creating headwinds throughout the economy, including the critical arena of lending. As a recent report from the Cleveland Fed shows, business loans are still falling and “the rapid pace of the decline is especially conspicuous when lending growth is compared across past recession-recovery cycles,” as a chart from the study shows (see below).
The negative trend of late in the economy will continue to play itself out until a new catalyst intervenes. Ideally, the catalyst would be a large surge in job creation. But that’s unlikely anytime soon. A more likely scenario is that at some point the market stabilizes as the crowd becomes comfortable with the new normal.
Meantime, it’s a mistake to think that the falling inflation outlook is speculative. As the IMF study reminds, the falling inflation observed in 25 historical instances in past decades had a common denominator: “…weak labor markets and/or high unemployment and falling wage growth.” That, of course, describes economic life in these United States today. The one bright spot, so to speak, is that in those 25 historical cases is “the observation that disinflationary pressures within episodes have tended to taper off at very low inflation rates.”
In other words, outright deflation usually didn’t arrive. Rather, very low inflation persisted in most instances. What might tip low inflation over into deflation proper? Tightening monetary policy could do it. In fact, some measures of the money supply are contracting on a year-over-year basis. MZM money stock, for instance, was lower by 1.5% in early August vs. a year ago. In fact, MZM’s one-year percentage change has been negative since March, according to data from the St. Louis Fed (see chart below).
Quantitative easing may or may not be the solution now that nominal rates at just about zero. But it looks like we’re still a long way from QE 2.0.