This August, the global Central Bankers conference in Jackson Hole provided significant insight to global economic conditions. Mario Draghi was the center of attention as he sent signals of a European Central Bank easing effort to “stabilize prices”. Most of my life, “stabilizing prices” meant keeping inflation under control. However, Mario Draghi is trying to avoid deflation of prices. I needed to go to my history books for this side of price stability. Meanwhile, across the pond in the U.S. Janet Yellen’s experiment with monetary policy is to focus on wage and employment growth.
This is a significant departure from the central banks historical role. The role of the Federal Reserve (Fed) has been to stabilize prices in the economy. The Fed accomplishes this by attempting to provide enough credit to the economy to support the expansion of economic activity without creating too much money to chase too few goods being produced. Most people my age are painfully aware of a prolonged policy of creating more credit than production output. The devastating inflation of the 1970s was a result of nearly 10 years of poor monetary and fiscal policy. Inflation reached 13% in the 1970s* and wages quickly lost purchasing power resulting in stagflation. The new threat of deflation has not been experienced since the 1930s and the 1870s before that experience.
So, we do not have a lot of experience with mitigating deflation. In fact, I do not think there is anyone alive today who was actually involved in fighting deflation. Therefore, we only have our economic history books to try and understand the effects of deflation. It is not quite clear why the Fed is targeting something completely new; (wage and employment). Many of us are bewildered. However, it sounds good. Unfortunately, history provides a dismal track record for the economy when the Fed deviates from the main mission of stabilizing prices to create an environment of growth and economic stability.
One fact we do know about deflation is the following: governments with large debt loads fear deflation the most because their debt must be paid back with more expensive dollars. While inflation allows heavily indebted countries to actually substantially reduce their debt in real dollars, this is accomplished by using the erosive effect that inflation has on investors that buy their long term debt. If wages remain stable during deflation then real purchasing power increases. So, deflation has some positive effects if it remains mild. For example, during the period between 1870 and 1890, the average deflation rate was a negative 1.7%per year*. Yet living standards for individuals substantially increased during this period as wages remained stable, prices went down and economic activity expanded.
However, the deflation of the 1930s was so severe because economic activity contracted causing deflation, lost jobs and lower wages. We believe that deflation resulting from lower prices is not bad for our economy so long as the economy continues to expand as in the late 1800s. We believe events in Japan and the Bank of Japan (BOJ) activities need to be mentioned at this point.
During the Jackson Hole summit, there was not a lot of discussion of the BOJ’s attempts to right size a two decade long economic malaise in Japan. Haruhiko Kuroda, the BOJs Governor has been the architect of the feeble rebound in Japan’s economy which was accomplished with a massive quantitative easing (QE) program that was much larger, on a relative basis, compared to the QE programs within the U.S. The BOJ has targeted a 2% inflation rate as well as working to increase wages in order to reach a 2% inflation rate.
Japan also increased the consumption tax and they actually seemed surprised that the tax increase may be at the root of the recent economic slowdown in consumption which, not surprisingly, resulted in a setback in Japan’s economic recovery. Therefore, on a relative basis, the BOJ has failed to reach any of their economic targets with a massive stimulus policy that dwarfed the U.S. QE policy. We are skeptical of the effectiveness of all the central banking activities evolving globally.
The Central Banks are taking credit for avoiding a depression, but we have no way of knowing for sure if this is true. It’s kind of like a pilot taking credit for keeping the airliner at 30,000 feet. Is it the fundamentals of the plane structure keeping us at 30,000 feet or that the pilot has not pushed the nose of the plane downward? We as investors must begin to pay close attention to the activists monetarism evolving since the 2008 financial crisis, a crisis that was caused by the Fed and Congress permitting the over stimulation of the housing market.
Politicians blamed greedy Wall Street bankers for the financial crisis not the governments housing policy. However, Wall Street bankers have always been greedy but the government aggressively inserted itself in the housing market in 1998 with the housing affordability legislation, which promoted much lower under writing standards for loans. The greedy bankers just helped them facilitate their quixotic goal. Remember, it was the collapse of the mortgage market that sent the global financial system into a rapid and near fatal decent. So the bottom line is, Japan has been attempting to stimulate their way out of slow to a negative growth economy for two decades with little success. I remain skeptical that the U.S. Fed will find a different outcome than the BOJ.