Why the Lack of Inflation Is a Problem

Equity Markets Keep Pace

Equity markets continued on their tear last week, rising for the fourth straight week. The S&P 500 finished the week at a record high of 1667, following a five-day gain of 2.1%. The Dow added 487 points to climb 1.7%.

Economic data was mixed last week. Consumer data was positive, while manufacturing data disappointed. Inflation came in very soft, however, maintaining optimism that the Federal Reserve’s quantitative easing program would continue.

The week kicked off with surprisingly encouraging retail sales data. While the headline reading rose just 0.1%, this was well above consensus and reflective of a sharp drop in gasoline prices. The “core” measure increased 0.6%. The figure eased investor concerns that the payroll tax cut is eating into consumer spending habits.

The tail end of the week brought more positive consumer data via the consumer sentiment report sponsored by the University of Michigan. The measure spiked to 83.7 in mid-month May from 76.4 at the end of April. If the reading holds, it will be the highest level of the recovery. The report was lifted by both the current and expectations components, reflecting a growing optimism among consumers about the present and future state of the economy.

On Tuesday, the National Federation of Independent Businesses (NFIB) reported that the Small Business Optimism Index increased 2.6 points to 92.1. This was above consensus estimates for a reading of 90.5, but the report was fairly mediocre. Four index components improved, four were unchanged, and two declined. The overall index remains stuck below pre-crisis levels.

Source: NFIB

Small businesses continue to report taxes and government regulations as their biggest concerns. These concerns have increased in scope over the past 12 months, contributing to the sense that policy uncertainty is creating an economic headwind for the corporate sector. NFIB Chief Economist Bill Dunkelberg noted as much in his commentary: “The lack of leadership in Washington and the resulting uncertainty depresses consumers’ and business owners’ willingness to spend and invest, and make bets on the future.”

On Wednesday, the Federal Reserve reported that industrial production contracted by 0.5% in April. The underlying components were mixed, as manufacturing fell 0.4%, utilities declined 3.7%, and mining increased 0.9%. The manufacturing component saw weakness in both durable and non-durable goods, with contraction fairly widespread among industries. When viewed in conjunction with the New York and Philadelphia Fed regional manufacturing surveys (both unexpectedly contracted in May), there is renewed concern about the health of the US manufacturing sector.

Finally, there was more disappointing news last week in the form of housing starts. Housing has been an area of strength for the US economy, mitigating any systemic concerns about the report. Starts fell to an annualized pace of 853,000 in April, a sharp 16.5% decline from March. Starts unexpectedly jumped to above 1 million in March, however, so April may reflect a bit of normalization in the series. Building permits remained robust at over 1 million, suggesting continued forward momentum for new housing.

Why The Lack Of Inflation Is A Problem

Given the outsized role central banks are playing in today’s financial markets, inflation watching has taken on increased significance. It is widely assumed that continued easy money policies are only possible as long as price increases remain under control. At the same time, for a global economy trying to escape an extended period of weak growth and burdensome debt loads, low inflation is a double-edged sword.

Last week’s inflation data from the Bureau of Labor Statistics (BLS) indicates prices softened in April for the second straight month. The consumer price index contracted by 0.4%, while the producer price index fell 0.7%. A trend has emerged, as the only month of positive consumer inflation during the past six months was in February, when a spike in gasoline prices lifted the headline measure.

On a year-over-year basis, consumer inflation reached its lowest levels since late 2010 after falling to 1.1%. After hitting a near-4.0% pace in September 2011, the measure has slowly drifted down. A similar trend is evident in the core personal consumption expenditures (PCE) price index, which the Fed uses as its benchmark for inflation. That measure fell to 1.1% in March, a sharp collapse from levels seen just 12 months prior. Meanwhile, the headline PCE recently reached its lowest level since 2009.

Source: St. Louis Fed

Contained prices are viewed positively by many observers, but persistently low inflation is not the sign of a healthy economy. Indeed, look no further than Japan for a case study on why a lack of price increases is detrimental – and why the Bank of Japan is desperately trying to boost it with unconventional monetary policies. Fed Chairman Ben Bernanke cited deflation as his prominent concern in the 2010 Jackson Hole speech that preceded QE2. While those concerns ebbed for a period, they are becoming increasingly relevant given the current trend in prices.

Despite the meteoric rise in bank reserves and the monetary base during the past five years, the runaway inflation many feared failed to materialize. This is because an increase in the monetary base does not, in itself, produce inflation. The pace with which money exchanges hands in the economy is the primary driver. Inflation expectations remain elevated nevertheless: data compiled by BofA Merrill Lynch indicates economists’ estimates of inflation have been consistently too high during the recovery period.

Source: Business Insider

The lack of price increases reflects a lack of growth in wages and credit, two segments of the economy that remain stuck in neutral in the wake of the global financial crisis. The employment cost index of private workers’ wages and salaries stabilized well below pre-crisis levels, as employers squeezed unprecedented levels of productivity from the labor force. Measures of consumer credit reveal some growth in non-revolving credit, but this is almost exclusively student loans; revolving credit remains non-existent, and measures of bank lending have been stagnant.

Source: St. Louis Fed

The lack of credit growth undermined the classic money multiplier described in textbooks, as a lack of lending hampered the velocity of money. Without this uptick in lending activity, both economic growth and inflation (absent any commodity supply shocks) will continue to sag. While this may keep investors happy via a continuation of the Fed’s liquidity injections, disinflation or even deflation is not a positive signal of economic recovery. Nor will it relieve the burden of growing government debt, a yet unresolved issue.

Source: St. Louis Fed

There are signs, however, that some of these realities are changing. Recent data from the Federal Reserve indicated that business loans made by US banks increased to $1.55 trillion at the beginning of May. According to the Financial Times, this is 10% higher than one year ago. The Fed’s Senior Loan Officer Survey noted that, “survey results generally indicated that banks’ policies regarding lending to businesses eased over the past three months and demand increased, on balance.” Respondents cited increased competition as the impetus for easing lending standards.

On the labor side, a separate survey performed by the Atlanta Fed shows a noticeable shift in labor cost expectations from businesses. On average, firms reported that they expected compensation growth to increase 2.8% over the next 12 months. This is a full percentage point higher than the average growth seen in the employment cost index over the past year. The report noted that these expectations were prevalent among both small and large businesses, mitigating some concern that the Affordable Care Act is skewing results for smaller firms (via an increase in benefit costs for those businesses).

At this stage, however, these signals are too small and infrequent to point to a broader sea change in asset price behavior. Commodity prices are collapsing, and weakness in global growth – in both the developed and emerging world – are contributing to a general malaise in prices around the world. Investors should continue to monitor asset prices in the months and years ahead as we emerge from an unprecedented period of central bank intervention. While inflation upside has long been the fear among most market participants, the downside risk should also not be ignored.

The Week Ahead

This week is light on new economic data. Existing and new home sales highlight the schedule on Wednesday and Thursday, respectively. Durable goods are also due on Friday, but the volatility of that series undercuts some of its impact from a month-to-month perspective.

On Wednesday, minutes from the early May Federal Open Market Committee meeting will be released. Investors will scrutinize this document closely for any clues as to the Fed’s most recent thinking around a possible unwind to its quantitative easing program.

Central banks meeting this week include South Africa and Japan. The Bank of Japan is not expected to introduce any new policy this month following a raft of new measures at its last meeting.

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