Rate Watch #1199– What the Fed is Most Worried about - Deflation

July 15, 2019

By Dick Lepre

dicklepre@rpm-mtg.com

www.loanmine.com

Most discussion about the Fed and what it will do regarding rates and even money supply misses the point as to what the Fed’s biggest fear is. The biggest threat to the economy is something almost never discussed - deflation.

It is time to take a look at what deflation is, if there is any chance of it happening here soon,
and what the consequences might be.

Disinflation

Disinflation is a decrease in the rate of inflation. The rate of inflation decreases but its actual value
is still positive. If we use CPI to measure inflation, then we have been in a generally disinflationary environment since the early 80’s.

If CPI continues to fall it might hit and pass through zero and we would then have deflation.

Our focus for so long has been on preventing inflation that, even though outright deflation is a somewhat far-fetched scenario it is good that we are becoming aware of it.

What Happens in Deflation?

Just how close to deflation is the U.S. economy? Inflation (which hit a post-World War II high of 13 percent in 1979) is running at about 2.0 percent. It wouldn't take much to transform disinflation - progressively smaller price increases - into declining prices.

Deflation is the opposite of inflation. Prices of goods and services would fall over time. Cash would increase in value. Debt, which was no big thing in times of inflation, might prove fatal to municipalities, companies and individuals. Real (nominal less inflation) interest rates would rise and defaults might result. This could lead to chaos in banking. Debt heavy companies would feel pressure to cut wages and salaries. Folks with mortgages might not have any income as their jobs disappeared. In deflation, debt is a curse. A retiree on a fixed income would find himself richer each month. One might curse the mortgage broker who got them a 4% fixed rate mortgage. Each month the value of that fixed number of dollars would increase. The value of my home would decrease. Why should I make my mortgage payment? 

In deflation there is little incentive to invest in plants and equipment.  Why invest today if the expense of doing so will be less next year? In the first four years of the Great Depression, prices dropped an average of 8% per year and big chunks of the economy went down. 

An example of deflation killing an industry is Telecom.  Large capital investments in bandwidth
were made – some of it with borrowed funds – and the price of bandwidth collapsed.  The telecom industry was hurt by its own competitiveness, a side effect of a free-market economy. 

We were wrong.

One thing about inflation that we should be learning is that our notions about it have been wrong.  It was long assumed that low unemployment inevitably caused inflation. Classic thinking was that inflation starts to increase when the U3 unemployment rate went below 6%. Justification for this thinking was that when unemployment is low workers can demand higher wages and higher wages cause inflation. Without analyzing this is is simply the case that the notion that low unemployment caused inflation is not correct.

Fed Chairman Powell said this week “The relationship between the slack in the economy or unemployment and inflation was a strong one 50 years ago ... and has gone away.” Also, “At the end of the day, there has to be a connection because low employment will drive wages up and ultimately higher wages will drive inflation, but we haven’t reached that point. In many cases, that connection between the two is quite small these days.”

Inflation and deflation can be viewed in an historical perspective. In the book "The Death of Inflation," British economist Roger Bootle points out that inflation has been the exception throughout history, not the rule. British studies show that in 1932, prices were slightly lower than they were in 1795. And, according to Bootle, when one looks at prices dating back to the year 1264, 97 percent of all the price inflation in the last 700 years has occurred since 1940.

What is truly interesting lately is that the long-accepted notion that low unemployment would cause inflation is not correct. Bootle makes the case that the period of low unemployment causing inflation was either an exception or not causally cornnected.

While it seems far-fetched that any nightmare deflation scenario could occur soon the Fed still is concerned  because deflation can have severe consequences.

Technical Analysis from Jim Grauer

The 10-year Note should trade in the 1.95%-2.25% yield range for this coming week.

Detailed stochastic analysis is here http://www.loanmine.com/CustomPage378.x

 

Dick Lepre
Senior Loan Advisor

RPM | MORTGAGE
3240 Stone Valley Rd West
Alamo, CA 94507

Cell: 415.244.9383
eFax: 866.488.2051
BRE License # 01143973

NMLS #302379

Email:
dicklepre@rpm-mtg.com

 

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