Despite recovery signals, deflation more likely than inflation

Excess capacity

David Pett, Financial Post Published: Friday, June 12, 2009

Rallying equities, rising commodities and soaring bond yields have investors feeling scared that inflation is at hand. But with the global economy still running at half-speed, it may be too early to dismiss the threat of deflation just yet.

"Markets are running the danger of being the architects of their own demise here," said Derek Holt, vice-president of economics at Scotia Capital. "If they run too far on the supply-and-inflation trade, they will head right back into the soup again."

At the heart of the inflation-versus-deflation argument is the massive stimulus that the U. S. Federal Reserve has injected into the economy by way of near-0% interest rates and quantitative easing. Combined with that, there is growing optimism that the economy is heading for recovery based on a slowing decline in inventories and job losses. As a result, investors have abandoned the safe-haven trade in favour of such riskier assets as stocks and commodities, and bond yields have risen to their highest levels since the collapse of Lehman Brothers in September, 2008.

"On the face of it, market worries have some justification: If the U. S. economy is picking up and if the Fed is printing money, is that not inflationary?" Gabriel Stein, chief international economist, said in a note to clients. "But even so, market worries are -- at least for the time being vastly exaggerated."

Despite the Fed's monetary efforts, Mr. Stein said growth in the money supply, which accelerated from lows in 2008, appears to have peaked at the end of last year. As such, it is nowhere near rates consistent with trend output growth and thus inflation. With the U. S. economy already running a negative output gap of 6%, the lack of money growth will likely only result in a growing output gap. Ultimately, Mr. Stein says that will only put more downward pressure on consumer prices.

"Over the next four to six quarters, it is more likely that the level of consumer prices, ex oil, will fall rather than rise, let alone rise at any worrying rate," he wrote.

Mr. Holt contends that higher food and energy prices are helping drive worries about inflation, but so-called headline inflation, while already trending higher, doesn't necessarily mean core inflation will follow.

He explains that even the slightest improvement in demand can drive up food and energy prices because inventories are so low and vulnerable at the moment. "In particular, steel inventories in Canada and the U. S. are sitting at about 2 1/2 months supply. So even a gentle turn in housing market indicators will result in inflation in steel prices. I think that is true across a number of commodities."

But, he added, that doesn't lead to a breakout in core inflation. In fact, he doesn't expect to see core inflation for years, and expects it likely to fall in the coming months.

"In environments in which households and businesses are still cash flow constrained from lack of credit and wage disinflation is just starting to take hold, it is impossible to account for higher energy and grocery prices without crowding out discretionary spending," he said. "This is the worst recipe for the North American consumer. Bond markets are not seeing through that dynamic."

David Rosenberg, chief economist and strategist at Gluskin Sheff + Associates, noted this week that even when oil prices were at US$147 a barrel last summer and other commodities such as copper were also soaring, it had little effect on the consumer price index.

Historically there has been a 37% "pass-through" from commodity increases to core inflation, meaning for every 10% increase in the CRB index, the CPI would increase by 3.7%. However, during the cycle lasting from 2002 to 2007, a 118% jump in commodity prices translated into only a 21% increase in the CPI, or an 18% pass-through.

"So from my lens, if U. S. retailers had difficulty passing along commodity costs in the last cycle when credit was abundant, I fail to see how they are going to do so in the current and prospective environment of declining household credit growth, rising savings rates and near-record excess capacity in the product and labour market," he said.