Thursday, October 07, 2004

The General finally has found somebody with clout talking the talk of deflation. From Morgan Stanley's Andy Xie today:
I believe the global economy is headed toward either mild deflation or stagflation. If central banks cut interest rates in 2005 in response to slowing growth � an outcome of the oil shock � the global economy may be headed toward stagflation. If central banks focus on price stability and, hence, do not cut interest rate in 2005 despite slowing growth, the global economy could be headed toward low growth and low inflation with deflation in certain periods and some sectors.
Xie is particularly insightful in understanding that ultra-loose US monetary policy is built upon ultra-cheap manufactured goods from China. Persistent commodity deflation coming out of China -- not to mention the "dollar bloc" which lets US liquidity leak out of the US to East Asia -- allows the Fed to avoid the inflationary implications of its monetary policy.

That being said, Xie thinks China and East Asia writ large will be exporting inflation soon due to rising food and oil costs there.
Inflation in most economies is still restricted to food and energy. Financial markets do not expect inflation to spread beyond food and energy. The yield on US treasuries, for example, is negatively correlated with oil price at present; the market seems to believe that a rising oil price slows down the US economy and makes the Fed less likely to tighten and is not worried about the inflationary impact of rising oil prices.

I believe the complacency in the market may be misplaced. I see two reasons why inflation could spread beyond food and energy. First, the relocation of IT production to China may be coming to an end. The cost savings from the relocation have pushed the US import prices down but could be running out. This could signal the end of the downward trend in the US import prices for goods from Asia.
So which is it -- inflation (really, stagflation) or deflation? Xie parses the possibilities this way:
The balance between overcapacity and oil and food prices would determine if the global economy would feel deflationary or stagflationary.

The key to the outcome is how long the monetary bubble lasts and, hence, how high oil and food prices go. The longer the bubble lasts, the higher the oil and food prices would go, and the more likely the outcome is stagflationary. Even though oil and food prices would come down when the bubble bursts, their inflationary impact takes time to work into general prices.

Where oil prices peak out, therefore, would be a key to a stagflationary outcome. The bond market now appears to believe that higher oil prices are good for bonds, because it makes central banks less likely to raise interest rates. When high prices are high enough to cause a stagflationary outcome, the relationship between bonds and oil would reverse.
For my $0.02, Xie overestimates China's role as an inflation generator and underestimates the US as a generator of deflation in its own right.

First, while price indices for East Asian NIC imports have indeed risen since the depths of 2001-02, the annual inflation rate on all commodity imports from this region now stands at -0.7% and has been negative since 1996. Food production is indeed falling drastically short in China, but a revalued renminbi combined with rising consumption of US grain -- which itself has been falling dramatically in price since May -- should temper any serious food price rises.

Second, very strong US capital investment over the last year-and-a-half combined with newly flagging consumption growth and the continued failure of the market to produce a significant number of new jobs shows the US can generate its own deflation internally, as the most recent personal consumption expenditures price data shows.

The inability of either Japan or Germany -- the second- and third-largest economies in the world -- to generate internally driven economic growth or export inflation of their own only puts the exclamation point on.

Final score? Deflation defeats stagflation by 3.

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