We'll say right up front that there is a greater risk for a bout of deflation through the medium term than for inflation to even rise back into the Fed's implicit comfort zone. Let us say it again for effect: far greater risk.
This is not a call we feel we're going out on a limb on. Resource slack by any measure is significant and final sales at this point of the "recovery" should be far stronger. But our base case remains for continued disinflation not outright deflation. This view is predicated on our call that while we have long been in the slow growth camp, there should be some growth nonetheless.
The headwinds are significant as our regular readers know we have long highlighted. But we reject the notion that the US backdrop is a replay of the Japan lost decade experience. This view fails to appreciate the fundamental differences in our economies then and now. As we answer in the headline above: this is not Japan.
We think there are meaningful differences between the US today and Japan during the '90s. High on our list is the difference in wages. A straight forward construct of inflation reveals employee earnings are a primary driver. During the early part of the 1990s wages in Japan were averaging around 2.0%.
In contrast, over the last several years in the US we have averaged just over 3.0% growth. Place this outcome in context. We just came through one of the worst job cycles since the Great Depression and employee earnings held up remarkably well. This suggests wages are unlikely to be a source of additional deflationary pressure.
Wage growth has remained relatively robust despite the lackluster jobs backdrop. How can this be? Well, for one, productivity in the US has been nothing short of extraordinary. And here again is another major difference between the States and Japan. And, dare we say, another reason why downright persistent deflation is unlikely.
Productivity growth is far stronger today in the US than it was in Japan in the 1990s. In fact, it is more than 2x stronger than Japan’s has been over the last decade and about 3x stronger than their productivity was during the infamous lost decade. Weak productivity was the result of poor labor market fundamentals emanating from, among other things, slow-to-declining population growth.
One of the more bandied about topics when discussing the US and Japan is population. The divergence here could not be greater. While the US continues to hum along at a 1% annual growth rate, Japan’s population growth has been steadily slowing for the better part of the last three decades. More recently, it has been stuck in negative terrain on a yoy basis since mid-2008 (currently running at -0.1%). Fundamentally, a declining population is another source of downside pressure on prices, as domestic demand falls. The US is far from being in this camp at the moment.
One of the other ingredients for deflation is an overabundance of goods in the economy relative to the pace of sales (dust off those econ 101 textbooks!). Currently in the US, inventory levels relative to sales remain razor thin and should keep the downward pressure on prices manageable, despite the sheer lack of pricing power.
The average inventory/sales ratio currently sits at 1.25 and is well off the crisis highs near 1.50, when the dreaded D-word seemingly made its way back into the lexicon. Sales remain anemic to be sure, but we would likely need to see a slowdown similar to the late 2008 experience to elicit any sort of deflationary pressures on this front. In other words, a double-dip in sales activity.
This phenomenon was evident in the early-1990 Japanese experience. Inventory/Sales ratios jumped 15% from 1990 to 1995 and this helped take the annual run-rate of headline CPI from 3.2% to a -0.7% low. In contrast, the supply/demand balance in the US remains relatively constructive for prices.
Japan’s goods imbalance caused significant downward pressure on prices.
There is an important psychological element associated with deflation that should not be overlooked. The Japan scenario is a prime example. In some instances the Bank of Japan waited years before implementing policy measures during their lost decade. By that point, prices were already slowing and consumers had already come to expect prices would continue to decline. This allowed consumers to expect lower prices thereby giving deflation the opening it needed to take hold.
The Fed on the other hand acted rather quickly when it tackled the recent financial crises which prevented the roots of deflation from taking hold. The Japanese experience proves a useful guide. Consumer price expectations led actual prices by 1-3 quarters during the 1990-2000 period.
This is empirical evidence that expectations of declining prices fuel further declines in prices — as consumers put off purchases in anticipation that they will get better deals in the future. The subsequent decline in sales activity increases inventory/sales ratios and creates a supply/demand imbalance that is negative for prices. It is no wonder then that the Fed considers consumer inflation expectations to be crucial in their overall outlook for prices.
At the moment, US inflation expectations remain well anchored and are not suggestive of any imminent deflationary episode. In other words, there has not been a shift in attitudes on this topic – a necessary requirement to satisfy the psychological aspect of deflation.
As RBC’s U.S. Market economist, Porcelli focuses on high frequency U.S. economics and short-term strategy as part of the overall U.S. interest rate strategy effort. Prior to joining RBC Capital Markets Porcelli worked as the trading desk economist on Merrill Lynch's fixed income desk. Porcelli began his career working on the Open Market Trading Desk at the Federal Reserve Bank of New York.