Inflation Vs. Deflation

Revisiting the inflation debate requires first stating my own view, I am strongly in the deflation camp; the data doesn’t entirely support my position, but it is important that the readers know my bias.

A few days ago, one of the Bank of Canada’s deputy Governor made a speech yesterday in Quebec City was any indication of that institutions view of Canada’s growth prospects, the error term surrounding the BoC’s optimistic base-case economic scenario are far too high for any rate hike on the horizon.

“the recovery will be difficult… a good deal of the recovery is supported by expansionist budgetary and monetary policies and we are still waiting to see some momentum from the private sector” …”we’re not out of the woods yet”.

The case for Inflation

(a) Output Gap

The primary method by which the Bank of Canada (BoC) determines the risk of inflation within the Canadian economy is the size of the output gap, the difference between economic growth and potential growth.  Early in February 2010 the BoC stated that the Canadian output gap was just short of 4%, which is substantial.

 

But what if the numbers are wrong? There are in fact two assumptions that are left mostly unsaid (both from the IMF, and BoC) (1) that there is no production destruction; the output gap is a big fat guess, and (2) the presumption is that the government can monitor what production capacity is available.  In an industrial economy this is a very useful barometer, because you can “count stuff”, but what about a post industrial economy?  Services account for ¾ of Canada’s GDP, these are much more difficult to account for. In fact, we now know that BoC has a very poor record of determining the size of the output gap.

It is more than likely that the numbers above are a poor indicator, and that the Canadian economy is closer to full capacity utilization (yes, I know still no jobs!).  We are seeing some of this full capacity with the housing market, where prices across Canada are back to their pre-crisis level (except Calgary and British Columbia).  Demand for housing is outstripping supply, with historically low

(b) Asset inflation

The second factor is asset inflation, which appears to become a problem in Canada.  Housing has never been so affordable because of extremely low interest rates.  The demand supply structure is out of balance with a substantial drop in the number of houses for sale, and a very rapid increase in the number of new homes under construction.   

 

It would appear that Canada’s monetary policy is far too accommodative.  As a percentage of GDP, homes have never been cheaper

This is caused by the extremely low interest rates, although most Canadian finance their home on the basis of 5 year fixed mortgages – there is no 30 year fixed mortgages in Canada.  Building new homes is a solution, but at the same time there has to be a dramatic shift in the monetary policy to reduce  

(c)        Debt Monetization

This is not driven by Canada, but bad money drives out good.  Over the past few days Greece and its liquidity crisis seems to have transformed itself into a funding crisis, with the European Union offering what appears to be a blanket guarantee with virtually no concession on the part of Greece (which today also announced that its deficit was 16% of GDP and not 12%).

 

There’s not much point on quibbling on Canada’s total debt most of the 2009 quantitative easing is already being unwound, with the BoC assets having already shrunk from $40 billion to $30 billon (in the space of 5 months) with further reduction on 2010 down to a historical level of…ZERO.  Most of the assets the BoC acquired are high quality s/t term instruments or Canadian mortgage back securities – where real estate prices are now back to their pre 2008 levels.

The problem is the rest of the planet, the American’s will need to finance $3.5 trillion in government bonds – today there is a $700 billion predicted shortfall, which could easily be made up by domestic savers should the U.S. saving rates remain at the current 5% level.  The “decision” of core Europe to provide Greece with guarantees solves the short term systemic problem, but creates a much more important funding problem for Europe; since its 2010 funding requirements will be around Euro 1.7 trillion.  Something may have to give and some form of debt monetization will probably occur which could give rise to inflation. 

Overall, the risks are that the BoC misjudged the strength of the Canadian economy.   Aside from misjudging the output gap, cost inflation is largely exogenous to the system, largely outside the control of the Bank of Canada.  There is a real risk that inflation could arrive on our shores. 

Deflation:

(a)        Industrial Product Prices Index

Total production inflation over the past three years is near zero, even after taking into consideration the dramatic increase in energy prices spiking at $148 per barrel in September 2008.  Between January 2009 and December 2009 oil prices rose from $48 to $72 per barrel with virtually no impact on producer price index.  First, this is a demonstration that producer input costs are volatile but generally consistent.  In Canada, the single most important factor in determining the IPPI is the exchange rate.  

 

The BoC recognizes that the strength of the Canadian dollar has a dramatic impact on the inflation factors affecting the economy.

12-month change: The appreciation of the Canadian dollar is still the main factor in the decline of the IPPI

(b)        Aging Population

Aging population has a huge impact on consumer behavior (remember buying Christmas gifts for your parents – they’ve already got everything…in triplicate) Canada is better positioned than virtually any other OECD country.  Yet Stephen Gordon (University Laval) has been following the trend for several years now, and amazingly Canada’s demographics follow his worse case scenario.  Everyone has heard of Japan, Italy and China the three countries that face the most immediate concern.  

 

Aging population is an economic deflator, because consumption patterns change, as an example Japan has seen no economic growth for nearly 22 years, some of the blame for this rests on aging demographic.  Households are no longer forming, demand for consumer goods drifts down.

This factor is more of a long term trend, but not yet a “live” treat to Canada

(c)        Deleveraging

The McKinsey Global Institute recently release a report: Debt and Deleveraging:  The global credit bubble and its economic consequences.  It is a document that makes sobering reading.  Again the issue for Canadians is that most OECD economies have too much leverage (concurrently with aging population).  The study (see above link) has three key conclusions:

(i)                   Empirically, a long period of deleveraging nearly always follows a major financial crisis.

(ii)                 Deleveraging episodes are painful, lasting six to seven years on average and reducing the ratio of debt to GDP by 25 percent. GDP typically contracts during the first several years and then recovers.

(iii)                If history is a guide, many years of debt reduction are expected in specific sectors of some of the world’s largest economies, and this process will exert a significant drag on GDP growth.

I agree that my method is somewhat disingenuous, since the dices are loaded.  Bottom line, a global economy in  deleveraging mode will face greater risk of deflation than inflation.  The consequence of the excess of the last decade are already “bake-in” the next five years.  Meager economic growth will result in deflation