The recovery from the financial crisis has produced a raft of unintended consequences. Quite possibly the biggest is the absence of inflation and the emergence of deflation.
Is it time to talk about the "D" word?
You know, deflation.
I know that inflation has been and continues to be the big worry. And that's only logical, since you'd figure that with the Federal Reserve, the European Central Bank, the Bank of Japan and other global central banks pouring money into the financial system that we will have to see inflation at some point. And I think that continues to be a real danger: At some point, all that monetary stimulus will result in across-the-board asset-price inflation (in contrast to the selective asset inflation we're seeing now in areas such as residential real estate in China) and at some point all that central bank cash will start pushing up prices in general.
But we're not at that "some point" yet.
It looks like first we'll go through a period where the trend is, surprisingly, toward deflation. Not across the board -- I don't think we're looking at a global equivalent of the Japanese experience of the last 15 years, where prices in general fall and then fall. But we are likely to see strong deflationary trends in huge hunks of the global economy, and the trends will be strong enough so that stock prices, and investors, will notice.
Another surprise from the global financial crisis and the unprecedented experiments that global central banks are running an attempt to create a sustained recovery? You bet.
Jim Jubak
Here's what this period of deflation will look like and why it has made this unexpected appearance.
Just a reminder: By this point in the recovery from the crisis, global economies were supposed to be running toward dangerous inflation. That was certainly the premise behind all those recommendations (mine included) to hedge against inflation by buying gold or gold mining stocks.
With global central banks pumping cash into the financial system, inflation seemed a lock. Certainly, it was reasonable to believe that if the Federal Reserve, to take one central bank, expanded its balance sheet by some $3 trillion (the Fed's balance sheet stood at $3.53 trillion as of July 24) it would have some effect on inflation.
Reasonable, yes. Predictable, no. The recovery from the financial crisis has produced a raft of unintended consequences. And the absence of inflation and the emergence of deflation is quite possibly the biggest.
Certainly inflation is very low in the world's developed economies -- an annual rate of 0.4% in Japan, 1.6% in the United States (if you look at the core consumer price index or 1.1% if you use the Federal Reserve's preferred price index for personal consumption expenditures) and 1.6% in the eurozone. In each of those cases inflation is running below the central bank's target inflation rate.
It's higher in developing economies such as Brazil (6.7%) and China (2.7%) but in the context of the historical inflation rates in those economies, inflation isn't extraordinarily high.
Why this absence of inflation?
A part of the reason is happenstance. For example, the U.S. energy boom has added new supply to the global oil and natural gas market, and that has helped keep energy prices low even as the shutdown of Japan's nuclear power plants has added to demand.
But more important has been the direction of flows of all this global cash. It, by and large, hasn't produced a spike in consumer demand for reasons that range from the way that this cash has flowed from central banks into the global economy to the timing of programs of economic austerity in the eurozone and the United States. The increase in U.S. Social Security withholding taxes at the beginning of 2013 took money out of consumer wallets, for example, even as the Federal Reserve was trying to stimulate consumer demand, through the much more circuitous route of making consumers feel richer, and thus able to spend more, because the value of their houses had started to climb again.
The most immediate effect of central bank policies has been to make money cheaper to borrowers. Not all borrowers, mind you. Small and medium-sized businesses, whether in China or Europe or (less so) the United States, have found credit hard to get even as the biggest companies in national economies have found credit easy and cheap. (In the United States many consumers who wanted to take out a mortgage found that banks had tightened their credit standards so that they didn't qualify for a low-rate mortgage. That has only recently started to change.)
Some of that cheap money for the big guys has flowed into financial assets. The U.S. stock and bond markets -- and the U.S dollar -- have been major beneficiaries. It is extraordinary that as worries about the Federal Reserve's balance sheet and U.S. financial governance have mounted, the price of U.S. Treasurys climbed and the yield on U.S. government debt fell. The U.S. gets a credit downgrade from AAA and Washington demonstrates that it will lurch from financial crisis to financial crisis, and the yield on the 10-year Treasury note declines?
But that still left a good part of that cheap money available to the CEOs of big companies able to tap the credit markets in China or the European Union or the United States. At some companies that cheap money has been used to refinance more expensive debt and shore up balance sheets. At others it has been used to add new production capacity.
Add more capacity in the midst of a period of very slow economic growth?
Yes, for two reasons.
First, in industries where adding new capacity can take five or more years, companies have to build for projected demand. Waiting until the demand actually materializes is waiting too long. So in industries such as mining or semiconductors or autos, companies looking five years out as the economy stabilized in 2009 and 2010 -- and as the cost of money fell to near historic lows -- decided it made sense to increase capital spending budgets for projects that would come on line in 2014 or 2015, just in time to meet rising demand.
Second, in economies structured around incentives other than profit -- such as, say, job creation or market share or production volumes -- companies raised cheap capital to add capacity since that guaranteed the ability to raise more capital in the future and covered up a current lack of profits.
Borrowing money to expand -- so that the company could make government officials happy -- was a critical survival technique even if, by any reasonable profit and loss calculation, the extra capacity would not be profitable and would indeed increase losses. (Of course, these companies could "pay" for these losses by borrowing more from lenders who wanted to keep these companies in business.) China's economy, the world's second largest, saw many of its big state-owned companies follow this path.
The end result of adding so much global capacity in industry after industry wouldn't have been a river of profits even if the world economy had staged a robust recovery. But in a modest recovery that actually looks to be slowing currently, the result has been a glut of capacity that has hit profits hard as supply outpaced demand.
In China those effects were obvious in profit numbers announced on July 27. Net income at China's industrial companies rose 6.3% in June from June 2012, according to the National Bureau of Statistics. That was a huge drop from the 15.5% year-over-year growth rate in May. That number overstates the profitability of Chinese companies too, since it includes income from ancillary, often speculative, activities such as investing or real estate. Looking just at profit from main business operations, net income fell 2.3% in June, year over year, from an 8.8% gain in May.
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