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Changing the deflationary dynamic

Mr. Market is in a gloomy frame of mind. The imaginary person dreamed up by Benjamin Graham, the godfather of investment gurus, is expecting economic storms ahead. From the start of the year, powerful moves in world markets for bonds, commodities and equities have signaled a growing risk of recession and deflation. The likelihood is that pressure will grow for a radical policy response.

     Needless to say, the markets are not always right. Graham's protege, Warren Buffet, has termed Mr. Market "a drunken psycho" on account of his rapid mood swings. Nobel Prize-winning economist Paul Samuelson famously quipped that the stock market had predicted nine out of the last five recessions.  Yet that is an excellent record compared with the forecasting prowess of professional economists. According to International Monetary Fund economist Prakash Loungani,   the record of official failure to predict recessions is "practically unblemished," both in the private sector and in international bodies such as the IMF itself.

     The three big risk factors -- U.S. monetary policy, China and the commodities complex -- remain as opaque as ever. Although the U.S. labor market still seems in reasonable shape, corporate profitability is weakening and inflationary expectations -- as measured by the yield differential between inflation-adjusted and ordinary bonds -- have plummeted to the lowest levels since 2009.

     Meanwhile, the yields on lower quality corporate bonds have soared as investors prepare for a wave of bankruptcies. The Federal Reserve's interest rate hike in December is already looking as ill-judged as the Bank of Japan's tightening of monetary policy in 2007.

     Despite some recent signs of stabilization, commodity prices remain at levels that spell deep trouble for companies and countries that produce them. The Bloomberg Commodity Index is no higher now than in 1991. Shipping rates for dry-bulk carriers are at their lowest in 30 years, which portends a severe downturn for shipbuilding and associated industries.

     All things being equal, lower prices for energy and other commodities constitute a transfer of income from producers to users, who are ultimately consumers in most developed and emerging economies. However in a "noflation" world in which nearly every central bank is falling well short of its inflation target, the lower prices could embed deflationary expectations, just as higher commodity prices embedded inflationary expectations in the 1970s.

Halting disruption

Most commodity-producing countries have smallish populations which are unable to spend the money earned from their exports. The effect of the commodity boom which took off in 2003 was to impose a regressive tax on the incomes of consumers in the importing nations and transform the money into capital, which was then recycled into financial markets, prime real estate, contemporary art, sports franchises and so on. Turning that capital back into income is ultimately a welcome development, but the process is likely to be highly disruptive in financial and, probably, geopolitical terms. 

     In China too, there are signs of recent stabilization in indicators such as auto sales, but the deep downturn in trade continues. Most disturbing is the continuing drain on foreign exchange reserves, which fell by about half a trillion dollars in 2015. This is the result of the People's Bank of China's defense of the yuan in the currency markets, which came in the face of relentless capital flight -- the financial equivalent of "voting with your feet." What is unsustainable must come to a halt at some point. The obvious denouement is a large-scale devaluation of the yuan, which would effectively export China's excess capacity and deflation to the rest of the world.

     How will policymakers deal with the intensifying deflationary dynamic? Given the sullen political mood in most of the developed world, inertia is not an option. We can expect to see yet more radical experiments in monetary policy and a greater willingness to use fiscal policy.

     The quantitative easing policies followed in the U.S., Europe and Japan have been massive in scale, but so far conservative in content. Back in 2002, then Princeton professor Ben Bernanke recommended the deployment of "helicopter money" -- meaning a broad-based tax cut financed by the central bank -- as the best cure for deflation. 

     However during his chairmanship of the Federal Reserve, the focus was on the purchase of government bonds from financial institutions. Rather than entering the real economy, much of the money remained trapped in the financial system. In Japan and Europe too, the major banks have effectively been swapping government bonds for reserves at the central bank.

Radical change

The move to negative interest rates in Japan and Europe is the first step to a more radical approach. In Japan's case, a further move into minus territory could result in negative rates on mortgages, which should boost housing demand. The introduction of fees on large-scale corporate deposits -- already mooted by one of the megabanks -- would make Japanese companies think twice about their 300 trillion yen cash hoard. 

     Some households may choose to hold more physical cash, thus shrinking the banks' deposit base. That could be no bad thing, as the deposit base of Japanese banks is far too large in relation to loans. Consolidation of the regional bank sector, which contains a great many sub-optimal outfits, is also a priority. Meanwhile, Japan needs to take another look at fiscal policy. There should be no more consumption tax hikes until reflation has been achieved. Tax breaks for companies that raise wages and financial support for families with children should also be considered.

     How will we know if policies are working? Not by studying the forecasts of the IMF, the Organisation for Economic Cooperation and Development or private-sector economists. As ever, there is no choice but to rely on the mood swings of the psychotic entity known as Mr. Market.

Peter Tasker is an analyst at Tokyo-based Arcus Research.




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