March 17, 2015

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Is it time to have a candid conversation about deflation? The dollar is soaring, making imports cheaper. Energy prices have collapsed. Wage rates are not rising despite a clear tightening in US labor markets. Credit demand remains weak even near record low nominal interest rates. So, the Federal Reserve—faced with a dual mandate of maximum sustainable growth and stability in prices—is preparing to raise interest rates to fight inflation? This week at the NABE Policy Conference, we had the pleasure of hearing Alice Rivlin, recipient of NABE’s 3rd Lifetime Achievement Award for Economic Policy. She opined that we are facing a cultural lag and asked, “Why are we still so focused on fighting inflation?” She noted that the last time the core PCE deflator hit 3 percent was 1992.

Her discussion got me thinking about where demographics have taken us. We have a generation of baby boomers about to go on fixed incomes worrying about the bane of their early business careers. The Gen Xers were taught by baby boom economists, who mostly (except for Ben Bernanke) got Ph.D.s for arguing about the causes and control of inflation. Meanwhile, my three fully grown millennial children have never experienced significant inflation—and have attitudes about credit and debt based on expectations of slow earnings growth and a mountain of unpaid education bills. With Baby Boomers staunchly fighting against health care inflation, Gen Xers refinancing their way to deleverage and Millennials refusing to borrow for housing or cars—what is the source of future inflation? Overly aggressive government borrowing? Not in a world of global fiscal austerity. No, it is not inflation, but deflation—and a host of other issues, like wealth concentration and the impact of disruptive technologies—that are the key risks to the longevity of this business cycle.

Over the past year—and far more suddenly in recent months—we have watched nearly half of the world’s economy re-price itself substantially lower. The Eurozone is now on a 25 percent off sale. This basically just caught them up with Japan, which saw its currency slide another 15 percent against the dollar—as did Canada, Mexico and Australia. The British pound is off just 10 percent, while the Brazil real fell 25 percent and the Russian ruble 40 percent. The roughly $3 trillion in global oil sales are at a 50 percent discount, and many other dollar based commodities are on sale as well. Is it any wonder that surging US imports are stealing away the economic strength generated by strong domestic hiring—potential limiting first quarter real GDP growth to less than 2 percent? We still see US growth running near 3 percent in 2015, but the potential for acceleration to 4 percent—and a threat from inflation—is disappearing as free and open borders transfer some of our strength to now far lower cost competitors.

From a global economic perspective, the current policy settings are just about what the doctor would order if you wanted a long sustainable economic expansion. The US—the suburbs of the global economy—has recovered first and is outperforming as is typical of the most economically efficient sector of any economy in an upturn. Meanwhile, China—the low cost producer globally—has seen some of its cost advantage erased via devaluations, yet even in a domestic slowdown it continues to grow faster than its end markets. China’s currency has slipped only 2 percent against the dollar over the past year, so the symbiotic relationship of an importing US and exporting China—which now accounts for 40 percent of global GDP—will be shedding growth to cheaper competitors as the global expansion progresses.


The preceding is an abridged version of a commentary for McVean Trading and Investments, LLC and has been reposted here with permission of the author.

The ideas and opinions expressed in this blog are those of the author, and they should not be perceived as investment advice or as any other kind of advice.

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