The
State of the
By Richard B. Hoey, Chief Economist of The Dreyfus Corporation
ebate
First Quarter 2003
Reflation or Deflation
There is a major debate between the bulls and the bears on the U.S. economy and the U.S.
markets. This is a status report on the debate between the optimists and the pessimists about the
U.S. economy and the U.S. markets. The optimists expect reflation in the U.S. economy and the
pessimists expect a destructive deflation.
Reflation or Deflation?
The Roots of Deflation Risk
The most crucial debate in the markets today is
whether the prospects for the economy over the next
several years will be characterized by deflation or
reflation. This is a critical investment issue, because of
the implications for different asset classes. Stocks and
higher-risk bonds tend to be relative beneficiaries of
both anticipated reflation and actual reflation, while
the highest-grade long-term bonds tend to be relative
beneficiaries of both anticipated deflation and actual
deflation, all other things being equal. Uncertainty
may persist over the next few months, but in this
debate we are on the side of those who expect
reflation to prevail in the end.
The roots of today’s deflation risk lie in the 1970s. The
rise from minimal inflation to double-digit inflation in
that period created an anti-inflationary mindset
among a generation of central bankers. That mindset
led to policies which brought inflation down from a
double-digit pace two decades ago to low levels today
in many countries. In addition, the global free-trade
system has fostered persistent price competition from
emerging country exports. Strong domestic demand
in the U.S. has not been matched by strong domestic
demand abroad. Weakness in foreign domestic
demand remains a major source of deflationary risk in
the world economy.
We would define pervasive deflation as a broad-scale
and sustained decline in consumer prices which is
widely expected to persist.
The capital misallocation which occurred during the
boom of the late 1990s contributed to excess capacity
and fears of deflation. Excessively cheap risk capital
generated a rapid expansion of capacity in a number
of new economy industries in the years prior to the
onset of recession.
In the current context, we would define reflation as
a multiyear reacceleration in economic growth strong
enough to reduce excess capacity in the goods and
labor markets. We expect clear evidence of reflation to
emerge by midyear 2003. A full-scale reflation would
be expected to generate a rise in corporate profits
driven by an acceleration of corporate revenue growth
and rising capacity utilization.
There tends to be a cycle in the fear of deflation risks.
They are most intense when expectations for
economic activity have already dropped, stock prices
have already declined and Treasury bond prices have
already risen (1998, 2002). Once the consensus shifts
away from a fear of deflation, there is often an
increased potential for a reversal of these market
moves, due in large part to the anticipated effect of
anti-deflationary policies. Our most likely case over
the next several years is economic reflation in a low
inflation environment. A year from today, we expect a
substantially lower fear of destructive deflation.
Issue 6
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The Varieties of Deflation
Deflation is a word with many meanings. We believe
that a major deflation is one which is both sustained
and broad-based. The word deflation has also been
applied to temporary or narrow price declines, but
these are usually normal attributes of the cyclical ebb
and flow. We would not tend to label as a full-scale
deflation either (1) a temporary cyclical drop in
producer, commodity or goods prices or (2) a drop in
prices in a particular sector of the economy following
a sectoral boom. We would refer to these as cyclical
deflation or sectoral deflation.
The most dangerous deflation is collateral deflation
or debt deflation where the value of the collateral
underlying the financial system plunges and destroys
Currency and Deflation
The Financial System and Deflation
2
the net worth of the banking system. This occurred in the
1930s worldwide and in Japan a decade ago. Deflation
tends to become deeply entrenched if it destroys
the net worth of the banking system. In nearly all
deflationary periods, numerous defaults occur among
high-risk and medium-risk borrowers, as deflation raises
the real burden of debt and weakens both sales and profits.
There is a distinction between benign deflation and
destructive deflation. Destructive deflation usually involves
a balance sheet meltdown, which is much deeper and more
prolonged than the usual cyclical stresses. Mild deflation
can be benign if the pace of deflation is moderate and
balance sheet stress is limited. However, since even benign
deflation is accompanied by the risk of deterioration into
more severe forms of deflation, policymakers should
attempt to reduce deflation risk even if deflation is mild
and benign.
Central Banks and Deflation
Central bank policy has a dominant role in the trend of
inflation or deflation. Inflationary or deflationary
expectations can sharply shift the demand for liquidity in
the private sector. The shifting inflation or deflation
expectations of the public help determine whether a given
pace of money supply growth is appropriate, excessive or
deficient relative to the demand for liquid financial assets.
As a result, interpreting the basic stance of monetary policy
is not simple. In many deflations, central banks
underestimated the true severity of their policy restraint
until it was much too late. Persistent deflation is
generally the result of a monetary policy mistake.
By word and deed, the Federal Reserve has recently shown
that it has adopted a proactive anti-deflationary policy.
Many Federal Reserve policymakers have stated that
deflation will not be permitted to occur. Alan Greenspan
and other Fed officials have indicated that they would be
willing to adopt unconventional measures to prevent
deflation. We assume that this could include actions
designed to overcome extreme risk aversion. We are
convinced that the Fed has both the power and the
willingness to prevent deflation.
One key concept is “asymmetrical risk.” Since deflation is
hard to stop once it begins, it is better to take the risks of
too easy a monetary policy than of too tight a monetary
policy when deflation is a risk. A central bank can always
find an interest rate high enough to be restrictive.
However, a zero interest rate may be too high to be
stimulative in a deflation. Real interest rates (interest rates
minus inflation) can be high during a deflation even if
interest rates are zero. That has occurred in Japan in recent
years and has depressed demand in its economy. We believe
that the Fed has learned from the mistakes of the Bank of
The State of the Debate
Japan over the last decade and of many central banks in
the 1930s. Central banks generally do have the
power to prevent deflation, but have sometimes failed
to do so, often because they misunderstood the actual
effect of their policy.
The Financial System and Deflation
We believe that the U.S. banking system is currently
sound. There have been the usual cyclical loan losses, but
nearly all major financial institutions are profitable and
have a strong net worth position. Much of the credit risk
in the financially vulnerable industries was taken on
outside the banking industry during the boom. As a
result, the losses were widely dispersed among investors
rather than concentrated in the core financial institutions,
where it would have had a more leveraged impact. We
believe that since the U.S. banking system is sound,
deflation is avoidable as long as policymakers are
committed to preventing it.
Currency and Deflation
The distribution of inflation risk or deflation risk among
countries is influenced by currency values. Countries
can export their deflation problem to some degree when
they have a weak currency which stimulates their
exports. In the 1930s, this practice was referred to as
“exchange dumping.” In recent years, many Asian
countries have intervened by buying dollars that their
private sector chose not to buy. This fostered
undervalued exchange rates for these countries despite
strong exports and persistent trade surpluses. The
depressed level of the euro until recently had the same
effect, although it was more the result of lack of
confidence in European policy and economic prospects
than of intentional government policy toward the
currency.
While the level of a country’s currency influences its
trade balance and its inflation/deflation pressures, the
directional trend influences international financial flows.
We believe that the dollar needs to adjust to a lower level
but do so in a gradual way so that financial flows do not
become disruptive. In the meantime, the elevated level of
the dollar is causing the U.S. to import deflationary
pressures from foreign countries with weak domestic
demand. We believe that the high level of the dollar has
permitted foreign countries to depend on growing
exports to the U.S. and postpone the adoption of
growth-stimulating domestic economic policies. The
best solution to the worldwide risk of deflation would be
the adoption of policies overseas which would strengthen
domestic demand abroad.
The State of the Debate
3
Throughout the history of the world, war has been
associated with inflation due to increased demand for
goods, increased demand for labor and rising government
deficits, usually financed by money creation. While a major
broad-scale war or military buildup would tend to have an
anti-deflationary effect, that effect would be much more
muted in the event of a relatively brief military action. In
the current context, however, worry about war may
intensify short-term deflation fears because uncertainties
about future military action encourage companies and
consumers to delay some spending decisions until after war
uncertainties are reduced.
The degree of leverage is not the sole key to the
outcome of a risk crunch in a deflation-prone period. A
crucial factor is the flexibility of the economic system to
quickly recognize and respond to impaired value and to
redirect resources to businesses with sound business
plans, including those exiting Chapter 11. This flexibility
was missing in Japan, but is an important characteristic of
the U.S. economic system. The more flexible the
economic system, the more likely it is that the
disorderly phase of deleveraging can be a brief
cyclical episode and that the deflationary risks
will prove temporary.
Risk Cycle and Relative Performance
Deflation: Near Miss or Crash Landing?
Deflation tends to be accompanied by a rise in defaults.
With corporate revenues and earnings weak, high-risk
borrowers have difficulty earning enough to meet their
debt obligations. That’s why the spread of corporate bond
yields relative to Treasury bond yields can be regarded as a
fever chart of anticipated deflation risk. We believe that the
recent peaking of corporate bond spreads is an
encouraging signal of a transition from disorderly
deleveraging to orderly deleveraging.
A period of deflation risk can end either with a near miss
or a crash landing into destructive deflation. What
determines which path the economic system will
follow?
A risk cycle is a normal part of the business cycle, but
there is a difference between inflation-prone and deflationprone periods. In inflation-prone periods, rising inflation
raises fear of a future monetary policy tightening which
will depress future profits. In deflation-prone periods, the
fear is that current monetary policy is already so
restrictive that revenues and profits are likely to remain
weak.
The relationship between stocks and bonds tends to
be different in deflation-risk periods than in
inflation-risk periods. In inflation-risk periods, rising
inflation pushes up long-term interest rates and raises fear
that aggressive monetary tightening will lower future
profits and therefore depress stock prices. Thus, in
inflation-risk periods Treasury bond prices and stock prices
tend to move in the same downward direction as inflation
risks rise. In deflation-risk periods, Treasury bond prices
and stock prices usually go in opposite directions when the
risks of deflation and weak corporate profits intensify.
When deflation intensifies, the risk of defaults and
disappointing profits is intensified. Treasury bond prices
tend to rise while stock prices decline in response to a
worsening profit outlook.
We believe the U.S. has just passed the point of
maximum deflation risk. If we are correct, the
trend of a calming of deflation-risk fears is likely to
be sustained.
We believe that the four keys to avoiding a crash
landing into deflation are (1) a central bank
which is both willing and able to adopt a
successful anti-deflationary policy, (2) a banking
system which is sound at the core, so financial
stresses can be temporary rather than persistent,
(3) flexible and appropriate mechanisms for
reallocating both capital and economic resources
and (4) public expectations that the economy is
not trapped in deflation and is likely to expand in
the future. We believe these four factors align to
make a crash landing into full-scale deflation in
the U.S. quite unlikely.
Channels of Monetary Policy Impact
The Federal Reserve has eased the federal funds rate
twelve times over the last two years, from 6.50% to
1.25%. The traditional channels by which the lowering
of the federal funds rate tends to stimulate faster growth
in real GDP and current dollar GDP are: (1) housing,
(2) consumer durables, including autos, (3) dollar
weakness, (4) lower debt cost of capital, and (5) higher
stock prices, which both lowers the equity cost of capital
and bolsters consumer confidence through the wealth
effect. Over the last year, only the housing and
consumer durable channels have been operating fully,
and much, if not all, of their potential demand strength
has already been realized. The dollar has declined
modestly from its multiyear highs, but is still high
enough that U.S. domestic demand is being drained by
foreign countries with weak domestic demand.
Channels of Monetary Policy Impact
Leverage
War and Deflation
War and Deflation
The State of the Debate
4
World Reflation
World Reflation
The stock market and debt cost of capital channels for
transmission of monetary ease were largely blocked until
the fourth quarter of 2002. The confidence crisis in the
honesty of financial reporting postponed the cyclical
improvement in the cost of risk capital. As of early
October, stock prices were at multiyear lows and the
spreads of high-risk and medium-risk bond yields above
Treasury yields were at multiyear wide levels even though
yields had dropped for the highest-grade bonds. The cost
of risk capital (both debt and equity) was at crisis levels
relative to corporate sales growth. Since then, conditions in
the financial market channels have begun to improve, as the
stock market has risen and corporate bond spreads have
begun to narrow. The Fed eased aggressively enough to
generate an uptrend in stock prices and a narrowing of
credit spreads. The case for eventual reflation rather than a
drop into full-scale deflation has improved as conditions in
these two key financial channels have begun to improve.
U.S. Reflation
U.S. Reflation
We believe that the most likely outlook for the U.S.
economy over the next several years is reflation,
especially once war-related uncertainties are
reduced. The main reason for this is that U.S. monetary
and fiscal policymakers have been flexible and proactive in
adopting stimulative anti-deflationary policies.
Measured by real GDP, the recent recession was mild
because neither the housing sector nor the automobile
sector experienced their usual cyclical decline. Measured
by corporate profits, however, the recent recession was
severe. Facing the aftermath of the capacity and cost
buildup in the boom, plus weak corporate revenues in a
deflation-risk environment, corporations have so far
concentrated on improving their cash flow rather than
increasing their capital spending. The U.S. economic
recovery resembles a relay race in which there is a need
for a handoff from the housing and consumer sectors to the
corporate sector as the recovery unfolds. As long as
macroeconomic policy is stimulative enough to
create a downtrend in the debt cost of capital and
the equity cost of capital, this handoff from
consumer and housing demand to capital spending
demand is likely to occur.
The odds favor worldwide reflation. However, there are
currently greater problems with foreign macroeconomic
policies than with U.S. macroeconomic policies. Many
foreign countries have been reluctant to reform rigidities
which currently restrain domestic demand. Instead, they
have adopted policies which favored exports over imports.
We are confident that reflation will soon dominate
deflation in the U.S., but it is likely to do so more slowly
in Japan and Europe (especially in Germany).
Japan has been struggling to reform its deflationary policy
mix but has not yet succeeded in this effort. European
regulatory, fiscal and monetary policies have not yet shifted
to a pro-growth stance. Germany is especially vulnerable
to deflationary pressures because it entered the euro at an
overvalued exchange rate and has been reluctant to
deregulate its economic system. There are encouraging
signs that European policymakers are beginning to rethink
the macroeconomic policies which have generated such
disappointing growth. China is growing rapidly, but its
main engine of growth has been a dramatic growth in
exports. Overall, we believe that U.S. macroeconomic
policy is stimulative but that the pace of domestic demand
growth overseas may be a problem until policies overseas
shift to a pro-growth stance.
Inflation Risk in Three Years
Three years from today, in 2005, the main concern
may be inflation rather than deflation. U.S.
monetary and fiscal policymakers are pulling out all the
stops to stimulate the U.S. economy, so a strong preelection expansion in the 18 months prior to November
2004 is quite likely. Fear of a negative impact on the
housing sector might cause the Fed to tighten rather
hesitantly rather than aggressively over the next two years.
By 2005, both the labor and goods markets are likely to be
much tighter, especially if foreign governments finally
move toward the stimulation of domestic demand in the
meantime. Given the large current account deficit, an
eventual weakness in the U.S. dollar is likely. Deflation is
today’s risk, but will not necessarily be the crucial problem
several years from now. Once a problem is fully
recognized, it is usually well on its way to solution.
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This report represents the general economic overviews of Mr. Richard Hoey, Chief Economist of The Dreyfus Corporation, and does
not constitute investment advice, nor should it be considered predictive of any future market performance.
©2003 Dreyfus Service Corporation, Distributor
DRY-SOD-0103