Skip to main content
david rosenberg

Amy Sancetta

The U.S. consumer price index for August came in pretty much as expected with a 0.3-per-cent gain, but the big news was the flat reading on the "core" index (which excludes food and energy). This is the metric that the markets and central banks focus on since food and energy tend to be volatile and related more to periodic supply factors than fundamental demand factors.

This CPI core index has now been at 0.1 per cent or below for nine of the past last 10 months and the year-over-year trend, at 0.9 per cent, has been below 1 per cent for five months running. Historically, back to 1957, I can only see this sub-1-per-cent trend happening for this long in 1960 - when the U.S. economy was in recession.

So, after nearly two years of de facto zero per cent policy rates, a weaker U.S. dollar, dramatic expansion of the Fed's balance sheet and a 10-per-cent deficit-to-GDP ratio, the U.S. economy is on the precipice of a deflationary experience. Whether or not it actually happens is a different matter, but at the present time, the economy is flirting with it.

The last time the economy flirted with deflation was back in 2003 (when the Fed cut rates to 1 per cent), but back then it was led by the "goods" sector as the core goods CPI deflated to historic lows of minus 2.5 per cent on a year-over-year basis. At that time, the much larger share of the economy, "core services," was still seeing positive pricing at plus 2.6 per cent. The low in core CPI inflation was then plus 1.1 per cent and the housing and credit boom ensured that we took off shortly after hitting that prior low.

Fast forward to today and the deceleration in core CPI has been more broadly based across both goods and services. The core goods CPI was running at plus 3 per cent at the turn of the year - amazingly, even with a soft U.S. dollar and firm commodity prices - and is now at plus 1.3 per cent. So this pace has been more than cut in half.

The real kicker has been in core services. The aftershocks of the Great Recession have left disinflationary scars in other previously "cyclically insensitive" areas like education and health.

Delivery services and recreation are also currently disinflating at a pretty fast clip. The year-over-year trend in core services has slowed to a record low 0.7 per cent as of August after ending last year at 1.4 per cent. And, it's not clear from the trend or base-effects from last year that it has bottomed yet.

At a fundamental level, the forces that most contributed to disinflation in the last 30 years were globalization and technological innovation that lead to dramatic improvement in productivity and ever-lower unit labour costs. There is no reason to doubt that these forces will remain intact in the future.

What is important is to look ahead to what all the variables are that will contribute to the deflation forecast, including the ongoing dampening effects that the credit contraction is exerting on aggregate demand as well as an aging baby boomer cohort that will increasingly be focused on saving rather than spending.

While a deflationary spiral seems overly pessimistic even for a bear like me, the arithmetic still points in the direction of an ongoing decline in the underlying trend in consumer prices in the United States.

Of course, there are offsets from all the policy stimulus, but the reality is that the Fed does not have deflation as its base-case scenario and, as aggressive as chairman Ben Bernanke has shown he can be after the fact, rarely has he demonstrated an ability to be early.

Putting it all together and it is reasonable to conclude that prices are most likely to be stable for a generation, perhaps even on a mild downtrend. After all, since the U.S. is looking more and more like Japan, it pays to take note that Japan's CPI sits right where it was 18 years ago when its deleveraging cycle was in its infancy.

While a deflationary spiral seems overly pessimistic even for a bear like me, the arithmetic still points in the direction of an ongoing decline in the underlying trend in consumer prices in the United States. For example, if the core goods CPI were to ever revert to its historic lows of 2003 and bump against the current historic low in the core services CPI, then we would indeed slip into a mild deflation.

Food for thought, because that prospect is not remotely priced into nominal bond yields, even with the 10-year Treasury note sitting around 2.7 per cent and the long bond yield just under the 4-per-cent mark. Nor does it seem likely that, in such a challenging pricing and revenue environment, we will see the double-digit earnings trend still currently embedded in equity market valuation.

Report an error

Editorial code of conduct