Saturday, July 10, 2010

Deflation Warning

The always excellent John Makin sees a rising threat of deflation in his July 2010 American Entreprise Intitute Economic Outlook.


“U.S. year-over-year core inflation has dropped to 0.9 percent—its lowest level in forty-four years. The six-month annualized core consumer price index inflation level has dropped even closer to zero, at 0.4 percent. Europe’s year-over-year core inflation rate has fallen to 0.8 percent—the lowest level ever reported in the series that began in 1991.

Meanwhile in Japan, while analysts were touting Japan’s first-quarter real growth rate of 5 percent,few bothered to notice that over the past year Japan’s gross domestic product (GDP) deflator had fallen 2.8 percent, reflecting an accelerating pace of deflation in a country where the price level has been falling every year since 2004. As of May, Japan’s year-over-year core deflation rate stood at 1.6 percent.

By later this year, persistent excess capacity will probably create actual deflation in the United States and Europe. Moreover, the recent appreciation of the dollar, especially against the euro, exacerbates the U.S. deflation threat.

More recently, an ominous drop in commodity prices and commodity-sensitive currencies, such as the Australian dollar, has accompanied signs that the pace of expansion in China may be slowing rapidly, in part because of stern measures aimed at deflating China’s property bubble. The price of copper—a widely followed bellwether for global demand—has dropped 20 percent since April. A combination of weakening currencies in commodity-rich nations and lower commodity prices, coupled with a move toward deflation in the G3 economies, is a troubling sign that a series of rolling financial crises may lie before us. That outcome would seriously exacerbate the balance sheet problems of commercial banks worldwide that hold substantial quantities of debt that is less likely to be repaid in an environment of global deflation.”

The punch line:

“A persistent failure to respond to the dangers of further deflation, such as the premature removal of accommodative monetary policy apparently favored at the ECB or a sharp fiscal contraction favored by the European Monetary Union, would sharply elevate the risk of global deflation and depression.
… The G20’s newfound embrace of fiscal stringency only adds to the extant deflation pressure.”

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