Still Wondering, Worrying & Debating About Deflation

The market’s outlook for inflation has been meandering just below 2% since late June, based on the yield spread between nominal and inflation-indexed 10-year Treasuries. The implication: the jury’s still out on whether deflationary risks are the real deal or just a figment of the crowd’s imagination.

As of yesterday, the Treasury market’s 10-year forecast for inflation is 1.87%, down from around 2.45% in late-April. The good news is that we’re still a long way from zero, which prevailed in late-2008 during the height of the financial crisis.

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Despite the recent anxiety over deflation, one bond manager argues that the D risk still looks improbable, according to a story in yesterday’s Wall Street Journal:

A senior fund manager at bond-fund giant Pacific Investment Management Co. said Tuesday it is “extremely unlikely” the U.S. could see Japan-like deflation given that the Federal Reserve has the tools to combat a downward spiral in consumer prices.

But Mihir Worah, who manages Newport Beach, Calif.-based Pimco’s $17.87 billion Pimco Real Return Fund, admitted high unemployment and weak consumer spending—which the latest data show was flat in June—pose a risk to his outlook. His comments underscored a point made by Pimco’s co-chief investment officer Bill Gross, who said recently “it’s an uncertain world that’s tipping toward deflation.”

Unlikely or not, the demand for Treasuries is still strong, as you would expect if deflation threatens. Buyers at one point yesterday pushed the 2-year Note down to a record low of 51 basis points, according to MarketWatch.com.

In the long run, inflation is still a risk. But that doesn’t preclude a bout of the opposite. The challenge is deciding if deflation truly is a real and present danger. Clearly, the risk is higher today than it was earlier this year. At the same time, it’s premature to expect a broad-based, persistent decline in prices is destiny.

Scott Colbert, who oversees bond investments at Commerce Trust in Clayton, Missouri, tells reporter David Nicklaus that we can’t afford to ignore deflation at this point: “It [deflation] has a higher probability than the new inflationary spiral that other people are talking about,” argues Colbert. “There’s no one right answer, but it is probably going to take some more monetary stimulus and more nontraditional measures to convince people that the Fed is not going to allow asset prices to fall.”

In fact, there are bigger threats to focus on, opines Richard Robb, chief executive of Christofferson, Robb & Co. and professor of professional practice of international finance at Columbia’s School of International and Public Affairs. As he wrote on FT’s Economists Forum earlier this week:

If you want to worry about something, I can recommend the US current account deficit. By continuing to run deficits equal to 5 per cent of GDP as the US has averaged over the past six years, in a generation it would transfer assets to foreigners that are equivalent to its entire stock market. A modest depreciation in the US dollar would only be enough to stimulate a J-curve making imports more expensive and having little effect on the deficit. The magnitude of the adjustment is likely to be far more disruptive than what little overall price instability seems to be in store.

Maybe, although it’s hard to ignore the fact that a current voting member of the Federal Reserve’s Federal Open Market Committee (the group that sets monetary policy) is openly worried about deflation, as he explained in a new research paper. That’s a rare warning of the D risk from a central banker in the U.S. Of course, deflation is rare too. And since the Fed can prevent deflation if it’s so inclined, it’s not yet obvious that the general price trend is set to go negative. But that point raises a different set of questions: Is the Fed willing to engage in a new round of monetary stimulus by, say, purchasing more Treasuries at the long end of the curve? There’s a fierce debate on when such actions might start, and if they should start at all.

Deflation may be looming, but not necessarily for economic reasons alone.


Originally published at The Capital Spectator and reproduced here with the author’s permission.