Over the past two weeks or so, the words deflation and disinflation have popped up quite frequently in the news. Deflation is a situation in which prices are falling in absolute terms. Disinflation is a situation in which prices are rising but the rate at which they rise, the rate of inflation, is falling.
For example, Christine Lagarde, the managing director of the International Monetary Fund (IMF) stated that the developed countries of the world should not ignore the “orge” of deflation as some of them…particularly the United States…should not ignore the impacts that their monetary policies have on the rest of the world…especially on the emerging nations of the world.
Olivier Blanchard, chief economist at the IMF and on leave from the economics department at MIT, has also talked about deflation in recent days. Basically, he commented on the data that was behind the remarks of the managing director.
In his discussion he mentioned that in an deflationary environment, you would have higher real rates of interest and debt issuers, both public and private, would face a greater burden in having to pay back loans in depreciated money. Both of these possibilities could lead to further deflation because they would have the effect of causing an even greater slowdown in economic growth.
In the January 17 edition of Barron’s Gene Epstein, titles his column, Economic Beat, “More Disinflation Lies Ahead.” In that issue of Barron’s, a former Barron’s columnist, James Grant, is quoted talking about the fact that so much debt, public and private, is outstanding, that there is a real deflationary bias in the economy right now. “Debt is a force for deflation,” he argues, because “Encumbered firms produce to remain solvent. Heavily encumbered firms overproduce. Overproduction presses down prices.”
So, the issue of disinflation and deflation are on the table and need to be discussed.
To start the discussion lets get at what Mr. Blanchard is saying about real interest rates. Blanchard is talking about ex post real interest rates or real rates determined “after the fact.” That is, we don’t start out with an estimate of the real interest rate, we derive it from current “nominal” interest rates.
For example, the “nominal” yield on the 10-year US Treasury security is around 2.85 percent. If the actual rate of inflation, measured by the Consumer Price Index (CPI), rose from December 2012 to December 2013, by 1.5 percent, then the ex post real rate of interest is 1.35 percent.
If the rate of inflation dropped to 1.25 percent then the ex post real rate of interest would be 1.60 percent. That is, with no change in the nominal rate of interest a drop in the rate of inflation would raise the real rate of interest.
Mr. Epstein in his article in Barron’s writes that “The 2013 December-to-December increase of 1.5 percent (in the CPI) was down from a 1.7 percent increase in 2012….And both of the past two years’ increases were much lower than the 2.4 percent average annual rise over the past 10 years.”
To use another measure of the price index that economists like to use, let’s look at the implicit price deflator for Consumption Expenditures in the national income accounts. We do not have numbers for the fourth quarter of 2014 yet, but the rate of inflation between the third quarter of 2012 and the third quarter of 2012 was 1.1 percent. This was down from the fourth quarter to fourth quarter rate of 2.8 percent. Certainly, this presents a picture of disinflation.
In prices were actually to fall, we would have the situation where a 2.85 percent nominal yield on the 10-year US Treasury security would translate into a “real” rate of interest of 3.10 percent if the rate of deflation were 0.25 percent.
In terms of the real value of the debt outstanding, a decline in prices would mean that the person or government in debt would have to pay back the principal of the amount borrowed in dollars that bought more goods than when the borrowing took place. This means that the real cost to the borrower of paying back what he borrowed would go up, placing a more of a burden on the borrower than what he had obtained in the first place.
So, disinflation and deflation would result in rising “real” ex post rates of interest, just like Blanchard argued and deflation would result in a rise is the “real” debt burden making it harder and harder for debtors to pay back their borrowings.
Where are we now?
In over the past few months I have written about bond interest rates from the expectations, or ex ante, perspective, not from the ex post standpoint as was done above. I used the yield on the 10-year US Treasury Inflation Protected security (TIPS) as a proxy for the ‘”real” rate of interest. Currently, this security is now yielding right around 0.55 percent.
I have argued that the difference between this rate of interest and the “nominal” yield on the 10-year Treasury is the expected rate of inflation as determined by investors in the bond market. Over the past several weeks, this “expected” rate of inflation has been around 2.30 percent. That is, investors seem to believe that for the next ten years, price inflation will be around a compound rate of increase of 2.30 percent.
The yields on these two securities tend to move roughly in parallel with one another so that it can be said that the market’s “inflationary expectations” are relatively stable. They do change over time, but the movement tends to be incremental rather than highly volatile.
If anything the market’s expectation for inflation has risen over the past year. For example, at the end of 2012 and the first half of 2013, “inflationary expectations” averaged around 2.50 percent. So, expected inflation for the longer-term, has come down, but not by much.
The implication for the longer-run is that the efforts at quantitative easing on the part of the Federal Reserve is expected to result in more inflation over time, even though there might be some disinflation over the near-term.
In terms of how we should look at interest rates in the bond market, there are two ways to try and consider the impact of inflation…or disinflation…or deflation…on interest rates. You can look at real yields by subtracting actual rates of inflation from the current “nominal” interest rates or you can try to estimate what the market believes the future rate of inflation will be by subtracting the yield on the relevant TIPS from the current “nominal” yield on a bond of similar maturity.
I like to use the second method because it incorporates the market’s expectation of what future inflation might be and I like to think that business people make decisions based on what the future has in store for them rather than on what the past has actually been.
Current one-year rates of actual inflation may be declining, as they have been in recent years. As a result, future expectations of inflation over time have fallen, but the market still believes that the Fed’s efforts at monetary easing will still dominate over time and eventually lead to rising rates of inflation. I believe that this conclusion is the one that is more consistent with the current situation.
About John Mason
John has been the President and CEO of two publicly traded financial institutions and an Executive Vice President and CFO of a third. He has also spent time as an economist in the Federal Reserve System and worked for a cabinet secretary in Washington, D. C. In addition John taught in the Finance Department at the Wharton School of the University of Pennsylvania for ten years. He now currently has a column on the blog Seeking Alpha and is ranked number 3 in terms of readers on the economy. From this column, two books have been published this past year from earlier blog posts. John is active in the shadow banking world, the venture capital space, and in angel investing. Other than that John works with start ups and early stage organizations, for profit and not-for-profit.
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