How Globalization Creates Deflation and Why Central Bankers Care

Deflation is an interesting animal. From a Central Banker’s point of view, it is to be avoided at all costs. The average consumer may think of this, on the surface, as a positive. Digging deeper, the average consumer has a debt balance, and that balance is climbing as of late. Despite record low interest rates, debt is likely piling up because the cost to service that debt, as a percent of income, is on the rise.

fredgraph (28).png

This is where consumers (read: debtors) would prefer if deflation stayed inside. This is because the more debt you have, the harder it becomes to pay it. To illustrate, we can view wages as the price of labor. If the cost of goods falls, on aggregate, there is likely no upward wage pressure. This means that consumers are taking home the same amount of income, or less, and are likely in the same amount, or more, of debt.

With inflation-that is, if you are a debtor-you have a debt and that debt is a certain, nominal amount. As prices rise, so do wages, as a general rule. Over time, the number of dollar in wages outpaces the solid-state amount of debt. Could this be why central bankers, especially those in current account deficit countries, hate deflation? An unqualified yes would do here.

Now, on to globalization. The moment the world started trading mostly freely and mostly efficiently, whenever that was, deflation organically arose. In the US, companies could hire international labor to make goods at a fraction of the cost. The labor cost was so minuscule in some countries that the costs to ship the finished goods back to the country must have been inconsequential. To sum up in a sentence: Labor is a factor in the cost of goods sold, and when the cost of goods declines, so can the price.

Declining prices is the textbook definition of deflation, with or without any doomsday connotations attached. There are other prices that play a role besides labor. Energy is no bit player in this phenomena. Up until the technological advances in hydraulic fracking and off-shore drilling the US was at the mercy of the OPEC countries when it came to oil. What they would deem as supply was basically supply. Lower supply would equal higher prices-demand being equal. Now things have changed; according to the EIA, ” In 2016, U.S. net imports (imports minus exports) of petroleum from foreign countries were equal to about 25% of U.S. petroleum consumption. ” This, being a wildcard of sorts, is generally stripped out of the headline number, along with food.

One more topic deserves covering- Housing. US residential real estate, which over the past century has been evermore fueled by credit, carries a meaningful weight in the metric. Speaking of credit, home prices are at the whims of their own external forces, interest rates and therefore, the availability of credit. As we saw a decade ago, option-ARM mortgages and NINJA documentation make today’s credit conditions look vault-like.

fredgraph.png

In any case, home prices are steadily appreciating and forcing deflation to abate. The most recent reading points to a 6.3% price inflation from one year ago. The so-called “wealth effect” is surely welcome with the homeowner crowd.

Speaking of a wealth effect, risk assets have felt a lot of love in the inflation department over the past few years. As I have noted repeatedly, equity valuations are quite rich, credit spreads are quite narrow and investors are caring less about protections given to them on debt covenants. When you’ve got so much wealth, I suppose, one can stand to lose a few bucks here and there. In all seriousness,  the eroding margin of safety is pervasive.

So while the Fed printed roughly 33%of the fiscal stimulus needed to keep our country afloat a decade ago*,  a significant portion has gone into the hands of those with a home and/or investments. The aim here is not political , mind you, but economic. While housing is included in inflation metrics, risk assets are not. This is why I believe the Fed may be in for more rate hikes than the market is wagering. Inflation is here, just not necessarily accounted for.

While productivity may not be had here in the US- see share buybacks at lofty levels in leiu of extra capex- deflation may be exported from abroad. Productivity elsewhere may, like labor, more than make up for any cost of transportation and/or any tariffs.  This advancement that we have occasional falling prices to thank, may be stifled by barriers, physical or political.

Now that the White House is on a mission to bring back those jobs by lowering the corporate tax rate, among other things, we may see some of this neutralized.  The Wall Street Journal posted an article  today titled Less-Educated Workers See Biggest Weekly Pay Bumps. It noted “Year-over-year wage growth for high-school graduates outpaced wage growth for college graduates in each quarter of 2017.” Now you may be justifiably reasoning that 67% of our economy is serviced based and we are not particularly inclined to outsource our restaurant service to frontier economies. This may be true, but technology may be phasing out a fraction of the profession entirely, with last night’s trip to Olive Garden was proof.

In sum, technological advances are the catalyst to deflation. No matter what the central bankers may have you believe, if you are not flippant with debt-capital you should have little to worry about. While our current account deficit may be monumental, it is not as though we were just inking our quill to cut a check to our debtors. Without our debt, who would the world (read:China) sell/lend to.

Deflation, on a large and widespread scale, could create a structural and catastrophic assault on progress. I doubt China, who freely buys US Treasuries (despite rumors of moving on) to weaken it’s yuan for competitiveness would want the music to stop now. Ditto the rest of the developed world.  The dollar standard we live under has been beneficial to us and the world alike, so when a little productivity-related deflation comes about, remember that it has always been a part of capitalism.

 

 

*3.5T Fed BS Growth / 10T Federal Debt Increase

Advertisements