Why the world is not threatened by deflation
Gavyn Davies on the Collapse in the Far east
Monday 03 November 1997
In other words, market paranoia on this occasion was not triggered by the usual concerns that inflation would rise and that this would be followed by higher nominal interest rates, leading to a decline in both bond and equity prices. Instead, the panic in the past few weeks has been triggered by precisely the opposite factors - downward pressure on goods prices, leading to declines in profit margins, and potentially then to global deflation.
As deflation sets in, real interest rates may rise, because central banks are unable to reduce nominal interest rates in line with price declines, so monetary conditions are unintentionally tightened. This tightening then leads to further declines in demand - ie to a self-reinforcing slump. Bond prices rise sharply as equity prices collapse. To those investors who were raised in the inflationary 1970s and 1980s, and who may therefore think that this story sounds inherently implausible, there is no need to look back to the 1930s to find a real-life example of the havoc that deflationary forces can wreak - just look at Japan today. Last week, it was possible to find plenty of investors who believed that the chilling Japanese example was likely to spread to the rest of the world.
Support for this view is evident in the recent behaviour of world producer prices, which measure the prices of manufactured goods as they leave the factory gates. At the start of 1997, the six-month annualised inflation rate for producer prices in the major economies was around 2 per cent. Now, following the collapse in Asian activity, this inflation rate has declined to -1 per cent. In other words, deflation is already visible in the goods sectors of the OECD economies.
However, much of this reflects earlier developments in commodity prices, which fell sharply in the first half of this year, primarily triggered by a major weakening in energy prices. Commodity prices have rebounded strongly in the past three months, and importantly there are no signs of a significant fall in overall commodity demand at present, particularly for energy products.
Admittedly, the Asian meltdown shows every sign of getting much worse before it starts to improve, and this will sharply curtail global aggregate demand. There are also some fears that a decline in global equity prices could damage confidence and thus depress consumer spending in the US and elsewhere. Taken together, these factors could certainly depress global inflation, and if they prove large enough they could even lead to outright deflation.
However, it is more likely that the impact of these negative shocks will be more than offset by the positive impact of other shocks - for example, rising confidence and domestic demand in Latin America, Eastern Europe and the United States; a gradual recovery in confidence in continental Europe; and the general impact of very expansionary monetary conditions in most corners of the globe. In other words, no systemic fall is likely in aggregate consumer prices.
In judging the relative strength of expansionary and contractionary forces at present, four key points should be made. First, the monetary policy environment is scarcely conducive to global deflation. Growth in nominal GDP in the OECD area is running at around 4 to 4.5 per cent, which is at least 2 per cent higher than would be consistent with global deflation. On Goldman Sachs' indices of global monetary conditions, the major central banks are delivering exceptionally easy conditions at present; the easiest they have been for at least 20 years. Broad money growth is much stronger that the growth in real GDP, suggesting that liquidity is ample. Furthermore, should the growth in nominal GDP falter, there is scope, if necessary, for monetary policy to be eased further in all countries except Japan.
Second, the wealth effects from any likely stock market "crash" from current levels should not prove very significant. At the low point last week, world share prices were still up by about 9 per cent this calendar year, after a 14 per cent rise in 1996. The positive wealth effects from these increases in equity prices have not yet been fully reflected in consumer spending around the world. By the same token, any decline in equity prices from current levels would not depress spending immediately. In fact, after the inevitable near-term confidence effects had been absorbed, consumer spending might continue to rise as a lagged response to earlier increases in equity prices. This, indeed, was one of the lessons of the 1987 crash.
Third, Goldman Sachs has recently carried out some simulations to estimate the impact on the world economy of a much bigger economic shock from Asia than is currently forecast. Specifically, Goldman assumed a slump big enough to trigger an improvement in the current account of 4 per cent of GDP in the Asean countries, 2 per cent of GDP in the rest of Asia and 1 per cent of GDP in Japan. An adjustment of this size would cut 0.4 per cent off the level of US GDP, 0.3 per cent off European GDP and 1.6 per cent off Japanese GDP next year. The overall impact on OECD GDP is about 0.5 per cent - significant but not yet catastrophic. The impact on inflation is also important, but not path-breaking. Assuming a shock of the above magnitude, the world output gap would widen by 1 per cent, curbing world inflation next year by about 0.4 to 0.5 per cent. Nasty for some manufacturing companies, but not the end of the world.
Fourth, this shock occurs at a time when upward revisions to world economic activity in other geographical areas are taking place. The US is now expected to grow by 4 per cent this year, compared with an expectation of 3 per cent a few months ago. There have been modest upward revisions to European growth forecasts. Latin America is expected to grow by 5 per cent this year and next, Eastern Europe by 4 per cent in both years. Even if OECD growth were curbed by 1 per cent next year - an extreme assumption - the world economy would still be a long way from recession.
Importantly, this also seems to be the belief that the global central banks are operating on. While they would certainly be prepared to provide additional liquidity in the near-term in the event of a market meltdown, any easing will prove temporary. On occasions last week, bond markets have flirted with the view that the Fed might shortly be willing to ease policy, and keep rates lower, for several quarters. This is not at all likely.
In summary, Asia is a big place, accounting for about a third of world GDP, and it is suffering a foreign exchange and equity collapse similar to that in Europe in 1992/93. Anyone who thinks that these market shocks will not have severe continent-wide economic effects is clearly out to dinner, as well as to lunch.
But while Asia might be big, the world is a lot bigger - and it is important to remember that the rest of it is doing rather well.
As Voltaire once said, “Ice cream is exquisite. What a pity it isn’t illegal”
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