The first priority for repairing the economy, or at least for stopping the bleeding is returning prices to something approximating equilibrium. There’s still more work to do, as suggested in the inflation forecast embedded in the spread between the nominal and inflation-indexed 10-year Treasuries.
As our chart below reminds, the market is far from convinced that the deflationary risk has passed. It’s open to the idea…maybe. But not convincingly, at least not yet.
As of last night’s close, the Treasury market is forecasting inflation of just under 1% for the decade ahead. That’s higher than the near-zero inflation expected at last year’s close and into early January, and so by that meager standard the outlook has improved. But relative to a normal state of affairs, the trend of late suggests there are worries anew that pricing pressure is set for another burst of deflationary wind.
The rise in the spread from 2008’s close through early February suggested that pricing equilibrium was on the mend. A “normal” state of affairs is one of inflation, albeit ideally one measured in the 1%-to-2% range. Economic growth requires a bit of inflation and so without it there’s trouble afoot. As we’ve discussed, there’s been reason for thinking that maybe, just maybe, general pricing trends might soon stabilize. Even if that’s true, there’s no reason to think that the economy won’t suffer through bouts of additional deflationary windstorms. In fact, we’re expecting no less.
The potential for another setback on that front is reflected in the falling spread in the chart above. More direct signals of the risk come in today’s updates on new orders for durable goods and new home sales. The news on both counts for January is by now a familiar refrain: decline.
Fed Chairman Ben Bernanke said earlier this week that recession could possibly end this as this year comes to a close. “If actions taken by the administration, the Congress and the Federal Reserve are successful in restoring some measure of financial stability—and only if that is the case, in my view—there is a reasonable prospect that the current recession will end in 2009 and that 2010 will be a year of recovery,” he told Congress.
Perhaps, although events between now and then will test everyone’s confidence that the sun will again shine on the economy. The manic depressive nature of business cycles—particularly ones as extraordinary as this one—will be on display, and then some. The key challenge remains one of stabilizing the correction so that the deflationary revaluation in prices generally doesn’t spin out of control. There have been signs that the seeds of stability planted by the Fed and increasingly the Congress are taking root. In short, the past six months could have been a lot worse. But the storm is still raging and the danger that the sprouts may yet be washed out to sea hasn’t vanished.
Prices eventually find equilibrium. That’s both the good news and the bad. Finding equilibrium, after all, is another way of saying that current prices must fall. At what point will prices fall enough to spur demand? The government can’t change this relationship in the long run, nor should it try. Prices worth the name must reflect supply and demand in order to convey useful economic information that in the long run is essential to promote and nurture growth. But for shorter periods, there’s a case for government intervention. Even so, the burning question: Where does equilibrium lie? No one’s really sure yet.
The capital and commodity markets are struggling to gain some confidence on when, or if the deflation risk has passed. The encouraging signs so far this year offer reason to think that the worst is behind us. But that’s still probably a case of premature optimism. The deflation that currently threatens is, like most deflations, powered by an excess of debt, which the U.S. is awash in.
The unprecedented explosion in debt on consumer balance sheets over the past generation is now being addressed, and the most conspicuous evidence is the dramatic paring of debt. The sharp drop in debt outstanding among households as well as nonfinancial businesses late last year (as reported by the Federal Reserve’s Flow of Funds Report) is as striking as it is necessary. Trees don’t grow to the sky, nor does debt. The repairing of household balance sheets was inevitable.
The only question now is whether the government can manage the healing process in a way that doesn’t make the medicine worse than the disease. Your editor enjoys a modest bit of confidence that this necessary yet difficult goal is possible. But we’re not prepared to say much more than that until and if prices generally find equilibrium. Unfortunately, we’re still in the correcting phase, as today’s reports for durable goods and new home prices suggest.
Yes, it’s almost March, but there’s still a long road ahead for 2009.