Economic Affairs

Ghosts of deflation past are back to haunt us

The world is set for a period of deflation. Emerging markets, including China, cannot be expected to power the global economy. There is excess supply and inadequate demand, and economies with limited domestic demand, dependent on supplying to the world, will be hit.

The ghosts of deflation past have returned to haunt global stock markets. The casualties have spread from other emerging markets to China and, now, the developed markets are affected as well.

Since the global financial crisis, the world has found itself six years older but none the wiser on how to fix the economy, for all the money printed around the world.

The major economies of the world - the United States, euro area, Japan and even China - fell into deflation as a result of the global financial crisis in 2008. At one stage, it looked as if quantitative easing had overcome inflation in the US, and economic recovery would also lift Europe and Japan out of deflation. Not so.

US inflation has been declining relentlessly since 2012. Prices in Europe and Japan are - beyond the initial rebounds - borderline deflationary again. The ghosts from 2008 were never exorcised. Even China has been suffering relentlessly declining consumer price inflation for the past two years and its producer prices are now clearly in the grip of deflation.

Although quantitative easing did not do much to lift either economic growth or consumer inflation, it did a lot for asset prices. The US Federal Reserve drove down yields by buying US Treasuries. In the process it forced yields lower for other asset classes via yield relativities across portfolios.


Thanks to the Fed's relentless suppression of asset yields over the past six years, stock and corporate bond prices have been driven metaphorically through the roof. They are now priced for perfection in a quite dysfunctional world.

Meanwhile, corporate earnings have fallen in the emerging markets. In the US, operating profit margins have hit a cyclical peak and are likely to revert to the mean.

The US dollar is now, metaphorically speaking, carrying the weight of the sluggish global economy on its shoulders. All this suggests US corporate earnings growth could continue to flatten out, even while analysts are expecting an upturn this year. That is, the market faces the risk of earnings disappointment.

So markets are now "rioting".

Actually, there had been mayhem in emerging markets for months. And now it is officially in a "bear market" - it has fallen more than 20 per cent since April.

But the steady decline in emerging market stocks over recent months passed without much fanfare in the press.

After all, Chinese equities were still roaring. But that, too, came to a nasty end in June - China is now in the grip of a bear market as well. The latest is that developed markets from New York to Sydney are in turmoil, too. While the reasons are many and varied, the common underlying theme is slowing growth and deflation.


Beyond the initial rebound off deep contraction, the underlying pace of global growth has been lacklustre. Indeed, in the period since the global financial crisis, there has been a significant downshift in economic growth compared with the 1990s and from 2000 to 2007.

The awful fear is the world has yet to generate self-sustaining growth even as the cycle of government policy support matures.

So what happens when stimulus ends? The markets fear the Fed will aggravate slowing growth and deflationary tendencies by raising interest rates.

Inflation has been on a downtrend since 2011. Beyond an initial rebound in consumer prices from 2009, the global economy never overcame the structural tendency towards deflation.

The world trade price index has fallen sharply over the past 12 months. Mirroring that, China's producer price index (PPI), which had been struggling in contraction territory for years, fell deeply negative over the past 12 months.

At last count, the PPI was deflating by 5.4 per cent year-on-year. Indeed, deflationary tendencies would have been a major consideration behind the interest rate cuts in China from late last year and, more recently, the yuan devaluation.

That is, on the basis of producer prices, real interest rates in China would have been almost 9 per cent at the time of the benchmark lending rate cut in November last year. Meanwhile, yuan appreciation exacerbated the deflationary environment.

In the US, core PCE (personal consumption expenditure) inflation has fallen markedly as well over the last 12 months, to 1.3 per cent at last count, well below the Federal Reserve's 2 per cent inflation target.

Both Europe and Japan are borderline deflationary economies (again). Commodity prices and freight costs have been plummeting as well.

The collapse in the prices of commodities over recent years is troubling on a number of fronts.

Quantitative easing was supposed to lift commodity prices by debasing paper currencies. But it didn't work.

Note that this was one of the strategies that lifted the US out of the Great Depression.

Today, commodities are adding to deflationary pressures, rather than reversing the tendencies. Emerging market economic growth slowed as expanded commodity production started to hit the markets, resulting in gluts. Falling commodity prices further damaged emerging market economies. Emerging markets then exported deflation to developed economies via weaker currencies and lower input prices. There is a risk of a negative feedback loop developing here.


A related issue is whether emerging market economies can sustain the high rates of growth of recent years. There is obviously a cyclical element to the current slowdown. The risk is a structural downshift. As academic Lant Pritchett and former US Treasury Secretary Lawrence Summers wrote in their 2010 paper, Asiaphoria Meets Regression To The Mean, "history teaches that abnormally rapid growth is rarely persistent, even though economic forecasts invariably extrapolate recent growth. Indeed, regression to the mean is the empirically most salient feature of economic growth". To take the case of China, there is a clear case for more investment - funded by China's prodigious savings - to lift productivity and growth. The problem is that the state-controlled financial sector appears to have been misallocating credit to inefficient and unproductive sectors of the economy - hence the surge in the amount of credit required to generate each unit of economic growth.

And much of that misallocated credit has turned sour. European economies, particularly Spain, Portugal, Italy and Greece, have hit the limits of government debt to gross domestic product (GDP).

Spending cutbacks to reduce debt have slowed growth and fed deflationary tendencies.

In the US, household debt is being worked down significantly as a percentage of GDP, as households hold back on spending to reduce debt. The impact on the market is again deflationary.

The obvious solution to the global imbalance between a China that saves and invests too much and developed economies that borrow too much is for China to spend more - hence the argument that China should shift the consumption share of GDP from around 40 per cent to something closer to the 70 per cent in the US.

But people don't conveniently change the deep structures of their cultures and behaviour simply because economic policymakers wish they would. A sharp shift from saving/investment to consumption is unlikely to happen in China. Meanwhile, cutting back on investment growth has been a drag on growth and prices.


Ageing demographics and low productivity growth have also been structural drags on growth.

Lower fertility rates in previous decades are now showing up in shrinking work forces - and hence lower potential output growth. Changing demographics also impact prices. It had been argued that the baby boom after World War II led to the inflation of the 1970s as marriages and new household formations drove a surge in demand.

Extending that family consumption cycle to today, older people who continue working but spend less than in the prime of their lives add to deflationary pressures.

Meanwhile, productivity growth in the developed market economies has also shifted down. In the US, for example, it has been estimated that from 2011, the annual productivity growth rate averaged only 0.9 per cent, compared with 2.8 per cent in the period from 1994 to 2004. Total factor productivity has declined markedly over the past 10 years in many parts of the world.

So what now?

If I could imagine a thought bubble from Fed chairman Janet Yellen - a caricature, of course - she might be thinking of emerging markets and Asia as she delivers the rate hike, whether next month or a couple of months later: "This will hurt you more than it will hurt me."

Viewed in another way, this is a world of inadequate demand and excess supply. There had been a series of competitive devaluations around the world, starting with quantitative easing in the US and a weaker dollar immediately after the global financial crisis.

But since then, rates have been cut all around the world. The Japanese brought back ryoteki kinyu kanwa (that was the Japanese expression for quantitative easing when they first introduced it in 2001) with a vengeance, massively devaluing the yen. Then the Europeans introduced negative central bank deposit rates and quantitative easing. And now China is devaluing its currency.

They are all doing the same thing - that is, exporting their deflation or attempting to stop somebody else doing that to them in a world of inadequate demand.

In such a world, the suppliers - the emerging markets, for everything from commodities to manufactured goods - are at a disadvantage. Economies with demand are likely to enjoy a bit more insulation from the shocks. But mind you, they are not immune from a slower world. And this will show in the coming days and weeks in the equities markets.

  • The writer is chief investment officer at DBS' Consumer Banking Group and Wealth Management.
A version of this article appeared in the print edition of The Straits Times on August 26, 2015, with the headline 'Ghosts of deflation past are back to haunt us EconomicAffairs'. Print Edition | Subscribe