DeAnne Julius assesses the risk of global deflation as quite high in her keynote speech at The Banker Awards 2002 dinner.
As a former central banker, I know how finely attuned policy makers' antennae are to the earliest signs of inflation. Monetary policy works with a lag, so it is no good waiting until the signs are clear and inflationary momentum has taken hold before reacting. The inflationary overshoots and subsequent recessions of the 1970s, 1980s and early 1990s taught us that. But our policy makers may now be missing the early signs of an unfamiliar and potentially more dangerous scourge: deflation.
I do not mean dis-inflation, which is a declining rate of inflation. I mean deflation, a rate that has turned negative: where average prices across the economy are falling, year on year. This is a state last seen in the UK in the 1920s, in the US in the 1930s and in Japan today. It is not a comfortable state, either for central bankers or for the rest of us. It is better to err on the side of avoiding it, than risking it.
Yet, in my view, deflation is the biggest risk currently facing the world economy. In terms of its economic impact and likely duration, it ranks above a Middle East invasion or an oil price spike. The odds of a significant deflationary period are about one-in-three, in several major countries before 2005. If it happens, the banking sector would be among the most badly affected.
A deflation scenario
How might a deflation scenario emerge from current conditions? The story starts with today's global excess of capacity, not just in one sector, but across a whole range of internationally traded goods: electronics, telecoms, autos, steel and chemicals. These are all large sectors, together accounting for more than half of world trade in non-agricultural goods. Estimates of their capacity overhangs range from 20% (in steel) to more than 80% (in telecoms). Major service sectors are also suffering. There is such a glut of airline seats in the US that several large airlines have entered, or are on the brink of, bankruptcy. Investment bankers are still in excess supply, despite two years of job losses in New York and London.
You do not have to be an economist to know what happens when supply exceeds demand in a sector: prices fall and bonuses plummet. But, equally, as any economist will tell you, a few falling prices do not make deflation. For general deflation to occur, average retail prices across the economy have to fall. The story has to shift from the micro to the macro plane. To do that, it is helpful to think in terms of the macro-economic modelling framework used by most central banks and conventional economic forecasters. These models treat inflation in a symmetric way, whether it is rising or falling. So they can tell us about the conditions that result in disinflation, stable inflation and rising inflation - although they have nothing special to say about the case in which disinflation crosses "through the looking glass" into deflation.
In these models, the rate of inflation falls, with a bit of a lag, whenever an output gap between effective demand and potential supply begins to emerge. That can happen gradually when the economy is growing more slowly than its long-term sustainable rate. In the UK, for example, that rate is thought to be between 2.5% and 3%. In fact, inflation has been drifting gently downwards since the beginning of 1999, while UK growth since 1997 (to account for the lags involved) has averaged 2.7%. This lends support to the assumption that the sustainable rate of growth is around 2.75%. But, for the sake of the argument, let's be as prudent as the UK Chancellor and call it 2.5%.
How does that sustainable rate compare with the recent growth of demand? Over the year to June, the UK economy grew by 1.2%, which is less than half its sustainable rate. That means there is considerable disinflationary momentum already in the system.
The same is true in the other major economies, most notably the US. The US suffered a three-quarter long recession last year and, after the false dawn of an inventory rebuild, nearly slowed to a halt in the second quarter of this year. The excesses of the 1990s have left corporations and consumers with high debt service levels, even with interest rates at 40-year lows. Balance sheets will have to be repaired, which means lower investment and consumption, perhaps for a prolonged period. A weak and faltering recovery in the US is the best that can be predicted at this point; a second dip into recession is a distinct possibility. That would cause the US Federal Reserve Bank to cut interest rates again - but, at 1.75% already, there is little further stimulus available.
Turning points The eurozone economies are unlikely to grow by more than about 1% this year, around half their sustainable rates. There are hopes that next year will be better. However, concerns are also emerging about Germany's ability to sustain its recovery. The eurozone cannot be a global demand locomotive. In Japan, even the most optimistic talk is about reaching a turning point rather than robust recovery. Interest rates have been zero for many months and Japan has stepped into deflation. On micro and macro-economic grounds, inflation looks much more likely to fall than to rise in the coming year. What would it take to turn falling inflation - disinflation - into deflation? The short answer is: not much.
In the US, the inflation rate has been falling for more than a year and is now 1.5%. In the UK, the target measure of inflation, RPIX, has been bouncing around with seasonal food prices, but its core value is probably between 1.5% (its June reading) and 2% (its July figure). Another year of sub-trend growth in the US, Japan, Germany and the UK - the world's four largest economies - would leave us all precariously balanced on the edge of deflation.
Unrecognised problem
Why is this serious risk not more widely discussed? It is because most economists and central bankers are struggling to recognise the full implications of the fact that this cycle is different because it was triggered by the bursting of an asset bubble. The recessions of the early 1980s and 1990s were caused by an inflationary overshoot followed by rising interest rates and a resulting credit crunch. This time, inflation is already low and real interest rates are at neutral or below. But their stimulus is being offset by the large fall in household wealth and the rise in the cost of capital, brought about by the stock market declines. Central bankers are learning in real-time about this novel experience. Under such extreme uncertainty, some are slow to take action. Perhaps too slow.
If deflation turns from risk to reality, banks will face serious challenges. Corporate customers with significant debt, across all sectors, will become major credit risks. The value of their debt will grow with deflation, while their revenue streams will be shrinking along with the prices they can charge for their products. Banks will either have to reschedule their loans to allow more time for repayment or force them into default, perhaps contributing to a wider credit crunch.
Equity markets will be decidedly subdued in a deflationary world. Cash will be king and simple savings products will regain their attractiveness, even with very low interest rates. Weak equity markets will strain the balance sheets of insurance providers, however. In fact, in a deflationary environment, insurance risks and returns will have to be reassessed. Actuaries will not be much help in this: their valuations tend to come unstuck when economic conditions deviate from historical norms.
Corporate advisory work will shift from mergers and acquisitions to financial re-engineering based on a fundamental reassessment of the relative roles of debt versus equity, of dividends versus capital gains, of performance shares versus options, of all of those financial variables that are differentially affected by inflation. It is in this sense that the shift to deflation will truly feel like stepping through the looking glass.
Not disaster
This portrayal of deflation presents challenges but not necessarily disaster for the banking world. This is because I would not expect a two-to-three-year period of deflation to turn into a UK-style, 1920s depression or even a Japanese style, decade-long, rolling recession. I am assuming that the policy mistakes of the past will not be repeated and that monetary policy would be rapidly eased once the imminent risk of deflation is clear. There is not much further to go in the US or Japan, though. Fiscal policy relaxation, in the shape of tax cuts, is their next best bet.
In the UK, I place my hopes in the symmetric inflation target. Inflation has been below the 2.5% target level for most of the past three years, but it has always been possible for some members of the monetary policy committee to argue that it was about to rise. That will become increasingly difficult if the major world economies face another year of sub-trend growth.
It is time to take the risk of deflation seriously. Pre-emptive interest rate cuts should be high on central banks' agendas. Private sector banks around the world should stress-test their lending and asset portfolios. When it comes to the dreaded D-word, forewarned is forearmed, and prevention is a far better strategy than cure.
DeAnne Julius is a former member of the Bank of England's Monetary Policy Committee, former chairman of the Banking Services Consumer Codes Review Group and is now a non-executive director of Lloyds TSB
