One of the most provocative articles in the financial media relating the economy in recent weeks was a brief note by CNBC contributor Ron Insana — one of the folks on that network who consistently knows what he is talking about – calling attention to the determination of the major central banks to treat the threat of deflation (not inflation) as pubic enemy number one in a battle he concluded would last as long as the decade it took to bring inflation to heel in the 1980′s in the US. And if he is right in his thesis, we probably need to re-examine the conventional premise that, if and when the central banks succeed in bringing economic conditions back to normal, would that really mean a base interest rate of around 4% as in the past, or would a number much closer to 2% be the new normal? And how would that change our perspective on likely economic behavior around three major pillars of US economic activity: housing, autos and finance?
Insana’s point was brought home the same week by the extraordinary policy actions of the European Central Bank (ECB) cutting its base interest rate to .15% from .25%, and reducing the interest it pays on deposits with the Bank to a minus .10 %, as well as a new targeted long term refinancing operation to inject even more liquidity into the system in the face of persistently low inflation to try to stimulate more economic activity to boost Euro Zone GDP out of its near-zero state. In the words of London’s Financial Times on June 5, this was a “bazooka” move that would reinforce market perceptions that the ECB would actually keep its commitment to fight the real potential of a deflation spiral that has flattened the Japanese economy for over a decade. Markets first reacted skeptically by bidding up the Euro, but that short term move eased off as economic data continued to come in toward negative growth.
Remember: inflation erodes the purchasing power of the country’s currency and tends to favor debts – they pay back their bonds with cheaper money, so lenders demand higher interest rates to compensate. But deflation erodes wages, prices and asset values (like stocks and houses) so it also has a negative effect on purchasing power despite the lower prices that go along with it. Central banks have proven they can whip rampant inflation (at the cost of high interest rates and recessions if necessary), but are only experimenting with how to reverse deflation because they know their tools are limited. There is only so low interest rates can go – even into the negative – while rates can be raised to a theoretical infinity (Paul Volcker in the US got them to 20% for a time, as Insana points out, but he won the battle and the war against severe monetary depreciation.) It’s understandable that central banks would want to nip deflation in the bud. Volcker’s war took ten years; why would we expect a harder battle against deflation to take less time? If so, one begins to consider the possibility, along with Insana, that low rates will be with us a lot longer than most expect.
Eurobond prices have surged to new high, bringing interest rates down to levels not seen since Napoleon’s time as the market has been warning of incipient deflation – and to some degree betting that ECB President Draghi will be forced to a full-blown “quantitative easing” bond buying program as in the US. He signaled again he might be inclined towards this with his “we aren’t finished” statement accompanying the recent rate cut decision. In that event, today’s expensive looking Eurobond purchases will look cheap when the holders sell out to the ECB at even higher prices! So we can see the trap Draghi is caught in — the more he does to combat deflation (which he must lest Europe return to recession), the further he drives down rates with programs that will tend to keep interest rates quite low. In turn, such low rates put a downward pressure on US interest rates as investors pay up marginally for a safer bet on government and corporate debt here. Whatever one’s questions may be about the absolute strength of the US economic recovery, no one seriously argues that it is not far stronger relatively than Europe’s, even with our wintry negative growth in Q1 2014. Europe would pay ransom to get the 3%+ growth now expected for the US in the current quarter.
Despite this resurgence in growth, the US Federal Reserve is expected to maintain its tapered pace of reductions in bond buying and has insisted that even after that program ends and unemployment is reduced to .5% or better in the coming year, it nevertheless will not quickly move interest rates up to track the growing economy. Even if inflation hits 2%. It stated after its last meeting on April 30 that economic conditions may “for some time” warrant keeping the base interest rate “below levels the Committee views as normal in the longer run”i.e., 4%.
If CNBC’s Insana is right that the “longer run” path to vanquishing the threat of deflation could take at least a decade, then the Fed is only half way there now, and halfway to 4 is indeed 2. Seasoned investment managers like Mohammed El-Erian, late of PIMCO, have begun referring to “lowflation” fears as pressuring bond yields and Central Bank rates down. Although El-Erian said in the Financial Times on June 6 that he believes that the policy moves should ultimately result in a “self-correcting” move out of bonds riskier assets, thus normalizing rates to the conventionally expected levels, he does allow that the move downward in rates could also become self-reinforcing due to unforeseen events (like Ukraine). If that is the case, the sense that 2% might become the “new” new normal (ironically, a nomenclature first traced to El-Erian and PIMCO) that needs to be taken seriously.
Here’s what could happen. While mortgages would be cheap, price appreciation expectations for homeowners would be significantly reduced. A long battle with deflationary tendencies would make renting more attractive as an ordinary feature of middle class life, simply because it is economically smarter. Similarly, not owning a car might become more of a new normal, especially when Uber is replacing a taxis and has an $18 billion valuation in just five years of existence. Maybe the millennial generation sees what is coming. Better not to be an owner if deflation threatens the endurance of asset values.
Finally, financial institutions would have to come to terms with the constraints of the Dodd-Frank law and find new wisdom in Shakespeare’s “neither a borrower nor a lender be” and drift toward Ben Franklin’s “a penny saved is a penny earned.”
Renting a house, snagging a ride on your smart phone, and de-leveraging your balance sheets would truly be a new American way, with tremendous implications for policymakers including the Fed if a geopolitical or natural disaster hit and it was stuck at an already low interest rate. As noted investor Ray Dalio –- who is very familiar with the roots of the current Euro-deflation crisis – said, this situation would leave the Fed with little leverage itself to stimulate an economy under attack. Then we could indeed all be Japan! The first clues to whether we are headed in this direction will be to ‘connect the dots’ in the Federal Reserve members’ interest rate projections over the next couple years that will be released as part of their quarterly economic forecasts at the June 18-19 meeting. Here’s a bet there won’t be many 4%ers and more than a few 2%ers.
Recently published on The Huffington Post
By Terry Connelly, Dean Emeritus, Ageno School of Business, Golden Gate University
Terry Connelly is an economic expert and dean emeritus of the Ageno School of Business at Golden Gate University in San Francisco. Terry holds a law degree from NYU School of Law and his professional history includes positions with Ernst & Young Australia, the Queensland University of Technology Graduate School of Business, New York law firm Cravath, Swaine & Moore, global chief of staff at Salomon Brothers investment banking firm and global head of investment banking at Cowen & Company. In conjunction with Golden Gate University President Dan Angel, Terry co-authored Riptide: The New Normal In Higher Education.