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United States The Coming Deflation Scare Korea Beginning of Aggressive Easing Cycle View GEF Archive

		The Global Economics Team

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There’s no mistaking the emerging signs of lower inflation. The plunge in energy quotes through the end of October will alone prompt sharp monthly declines in US headline prices measured by the CPI in both October and November. And because wholesale price declines filter slowly to the retail level, the headline CPI may also slip in December and January.  Recent declines in agricultural commodity prices will spread slowly through the food complex.  Hard commodity quotes have also tumbled and some of those changes will work their way through the cost structure.  Energy and commodity price declines alone could promote year-on-year declines in the headline CPI by mid-2009.

Moreover, while “pass through” from exchange-rate changes has declined over the past two decades, the soaring dollar will reverse some of the run-up in consumer and capital goods import prices, and those reductions have yet to show up either at ports or at the retail level.  Measured by the Fed’s broad, trade-weighted index, the dollar has appreciated by 11.4% over the past year and more seems likely.  Such a reversal, moreover, could weigh on domestic prices.  That’s more likely now as inflation expectations crumble and a potentially severe global recession creates more slack in the US and global economies.  Measured by the University of Michigan’s canvass, 5-10 year inflation expectations have reversed all of their 60bp increase over the past year and again sit at 2¾%.  Operating rates have declined sharply and likely will slide further: For example, US industrial operating rates have tumbled 500 basis points from their summer 2007 peaks to 76.4% in September, 460bp below the average level from 1972 to 2007.  In addition, the housing bust will continue to create a glut of owner and rental properties, which will depress rents.  The rise in owners’ equivalent rent, which accounts for one-third of the core CPI, has decelerated to 2.4% – less than three-fifths of the level a year ago – and that deceleration probably will continue.

But before concluding that deflation is imminent, step back for a moment to review recent history.   As US inflation declined to a rate close to price stability in recent decades, recession has brought about periods of low inflation that have stirred up deflation scares.  So it’s not surprising that the last one arose only five years ago, following the bursting of the dot-com bubble.  Measured by the CPI excluding food and energy, “core” inflation tumbled from 2¾% when the recession formally ended in late 2001 to just 1.1% two years later.  That flirted with the low end of the so-called 1-2% “comfort zone” that then-Governor Ben Bernanke identified as consistent with price stability.  Indeed, core inflation measured by the personal consumption price index (the Fed’s preferred gauge) initially appeared to fall well below 1%; although subsequent revisions pushed it to the currently-published 1.3%.  As it turned out, deflation fears in 2002-3 were exaggerated.

Fast forward to today: Similar to five years ago, four ingredients likely rule out deflation.  First, it’s critical to remember that the current inflation decline largely represents a reversal of the inflation spike of early 2008, rather than ushering in a new era.  In fact, it may seem bizarre to discuss deflation now when inflation was a dominant worry this summer.  So far, there’s scant sign of deflation in any price measure or in inflation expectations.  Although headline prices likely will decline sharply in coming months, underlying inflation over the past three months is elevated at between 2.7% and 3.3%.  Surveys of one-year ahead inflation expectations are still over 4%. 

Second, we think companies will quickly cut excess capacity to balance supply with demand.  Unlike in the 1990s, corporate capital discipline has restrained industrial capacity growth to less than 1% annualized over the course of the current expansion, or one-third the historical average.  Coming cuts in capital spending should quickly tame the emerging excess (for a comparison with the 2002-3 period, see Clarifying Three Issues in the Deflation Debate, November 11, 2002).  Third, some of the emerging global declines in goods prices are clearly declines in relative prices, not prices generally.  They are a boon to consumers; the plunge in US retail gasoline prices alone from a peak of $4 gallon in July to below $3 will be the functional equivalent of a $150 billion tax cut for consumers − and more if prices fall to $2.25, as seems possible.  Indeed, this shift in the “terms of trade” benefits consumers and most businesses, even in commodity-producing countries (see Deflation and the Terms of Trade, November 25, 2002).  And most important, the Fed is easing aggressively and now quantitatively to influence inflation expectations. 

The economic and financial risks of deflation are clear. It would push nominal interest rates to the “zero bound”, and further price declines would increase the real cost of borrowing, worsening the economic downturn, increasing the burden of existing debt, and thus escalating defaults, bankruptcies, and bank failures.  It’s also problematic for policymakers: Once the funds rate hits zero, the Fed can no longer ease policy by lowering its usual interest-rate target. 

Nonetheless, the ultimate bastion of defense against deflation is a Fed committed to avoid it at all costs. There’s little doubt in our mind that policymakers appreciate both the potential costs and the need to act aggressively to prevent such a potentially disastrous development.  Citing the lessons from the Japanese experience, six years ago the Fed staff clearly laid out the case for aggressive action when inflation is low and falling (see Ahearne et. al., “Preventing Deflation: Lessons from Japan’s Experiences in the 1990s”, International Finance Discussion Paper No. 729, June 2002, and the transcripts from the January 29, 2002 FOMC meeting). 

Governor Ben Bernanke later that year summarized the strategies for avoiding deflation (see Deflation: Making Sure ‘It’ Doesn't Happen Here, November 21, 2002).  Among them: Conducting operations to bring Treasury or private securities rates down along the maturity spectrum, financing fiscal stimulus, and/or “quantitative easing” of monetary policy.  Back then such ideas seemed fanciful; today, they are standard components of the Fed’s and Treasury’s tool kit.  At the short end of the yield curve, officials are working hard to restore term money markets to full functionality.  Following the mid-September “run” on the financial system, their efforts to cap money-market yields through existing and new liquidity facilities, combined with the FDIC program to backstop bank liabilities, are starting to bear fruit.  And further out the yield curve, the Treasury has the power to buy securities of any maturity directly through the Troubled Asset Relief Program. 

We think more fiscal stimulus is coming soon, most likely totaling $150-200 billion, and possibly before the turn of the year.  Key ingredients: Assistance to state and local governments to fund $25-50 billion in infrastructure and matching funds for Medicaid.  Extended unemployment insurance and help for homeowners may also be included.  As long as recession and declining inflation are the predominant risks, there is no doubt that the Fed will accommodate any new fiscal stimulus (indeed, a presentation at the January 2002 FOMC meeting prescribed exactly that). 

“Quantitative” easing (QE) of monetary policy is the Fed’s other weapon to fight deflation.   Employed by the Bank of Japan starting in 2001, QE simply means that the central bank floods the system with liquidity.  The flood need not lower short rates; indeed, now that the Fed pays interest on reserves, a positive rate on them will enable policymakers to do QE at virtually any funds rate.  In practice, it seemed to work better in Japan when combined with direct purchases of longer-term debt (see Mark Spiegel, “Did Quantitative Easing by the Bank of Japan ‘Work’?” FRBSF Economic Letter 2006-28, October 20, 2006).  

Against this backdrop, many investors expect that the Fed will cut rates to zero, with a first move at this week’s FOMC meeting.  The logic for going to ZIRP (a zero-interest rate policy) is perfectly legitimate: Financial conditions in risky asset markets have clearly deteriorated, there is evidence of economic weakness abroad, and the plunge in commodity prices and surveyed inflation expectations suggests a rapid decline in inflation is coming.  Even if deflation is unlikely, officials will want to counter any increase in real interest rates as inflation tumbles.  In addition, action is warranted to offset elevated counterparty risk.  Although they have come down, 3-month spot Libor rates are still some 200bp higher than we think is consistent with normal money-market functioning.  Third, the market environment is fragile and a tepid reaction from the Fed might disappoint market expectations.  Finally, the risk-management approach to monetary policy suggests that the Fed should pull out all the stops quickly in today’s extreme circumstances.

As we see it, a 50bp move in the Federal funds rate target is likely this week, but ZIRP may be slower to emerge.  The Fed has clearly moved to quantitative easing over the past six weeks, recently allowing the funds rate to trade some 50bp or more below the official target of 1.5% set on October 8.  Evidence of quantitative easing − made easier by the Fed’s ability to pay interest on reserves since early October − is found in the volume of excess reserves in the banking system, which climbed to $282 billion in the latest week, compared with a bi-weekly average of roughly $2 billion in the past.  Given the tentative signs of healing in credit conditions and money markets, and scant new information about the US economy since the global coordinated intermeeting interest rate cut on October 8, policymakers may not hurry to implement ZIRP. 

How should investors play deflation?  Near term, even if the FOMC holds off this week, investors should buy the front end of money-market curves as we expect easier monetary policy.  For now, investors should also buy bonds, defensive currencies like the yen and investment-grade credit.  Longer term, since we think deflation is unlikely, investors should buy TIPS; they are cheap inflation insurance.  Real yields are approaching 3% and 5- or 10-year inflation compensation is well below 1%.  And disinflation should ultimately be good for stocks, but not until the recovery appears.

Korea
Beginning of Aggressive Easing Cycle
October 29, 2008

By Sharon Lam | Hong Kong

Summary and Conclusions

In an emergency meeting earlier this week, the Bank of Korea (BoK) cut its policy rate by 75bp. The 75bp cut is the biggest move by the central bank in one day. The 7D repurchase rate is now 4.25%, the lowest level since July 2006. This is only the second time in the BoK’s current rate-setting history that it has made an inter-meeting move, with the first one happening shortly after September 11, 2001. 

We welcome the BoK’s decision, as it shows that the Korean authorities are not behind the curve and that they have grasped the problem. However, we do not expect that this aggressive rate cut alone can turn the economy around. The fundamental problem of tight domestic liquidity cannot be solved by lower rates, but has to be dealt with through liquidity injections, we believe.  Meanwhile, lower rates can relieve the interest burden for households and corporates; while this is crucial, it cannot generate growth until at least 2H09, in our view.

We had forecast a 125bp rate cut, but 100bp of cuts have already been implemented within a month. We believe that this is only the beginning of a more aggressive monetary policy, and we now look for a further 125bp of cuts to bring the policy rate down to 3% before the end of 2009.

Further Liquidity Injection Required

Despite the 25bp policy rate cut earlier this month, the market rate has not come down. The 91-day CD yield, a benchmark for lending rates, has risen 20bp since the last rate cut. Although we expect that market rates can be eased slightly after this week’s aggressive cut, the impact is likely to be muted, since the fundamental problem of tight domestic liquidity cannot be solved by lower rates alone.

Korea has the highest loan-to-deposit ratio in the region due to rapid credit growth in the last two years, coupled with households shifting away from bank deposits into brokerages.  Going forward, we believe that the loan/deposit ratio should decline, as lending has to come down while bank deposits have been rising sharply in recent months, as depositors are moving their funds back into bank deposits. This is because of higher interest rates, but more so due to the reduction in risk appetite. 

Although retail funding may improve, wholesale funding issues prevail, as foreign investors, who have been net buyers of US$47 billion of bonds issued in Korea in the last 24 months, could be redeeming due to continuous de-leveraging in the global financial market. While cutting interest rates is a step in the right direction, we believe that direct injection of liquidity is more necessary and would probably be more effective at this point, and the BoK has pledged that it will continue to do so.  Early redemption of monetary stabilization bonds, which are used to absorb the liquidity surplus in the banking system, is one way to inject liquidity back into domestic banks. The total amount of monetary stabilization bonds outstanding is KRW134 trillion. Meanwhile, the National Pension Service, which holds KRW228 trillion of assets, plans to cut its overseas investments to buy KRW8 trillion of domestic bonds before end-2008 as a means to ease funding pressure.

All these measures should help to ease the pressure but will probably not solve the problem entirely within a short period. We continue to see rollover risks for certain SMEs that are exposed to the deteriorating domestic economy and construction industry. 

Ensuring KRW Stability Is the Key

Korea’s foreign reserves at US$240 billion are enough to cover 1.4 times its short-term external debt; this contrasts with the ratio of only 0.3x during the IMF crisis 10 years ago. Most importantly, about 65% of the external debt accumulation in the last two years was due to exporters hedging and trade credits that are backed up by underlying export payments to be received. On top of that, 43% of the debt is actually held by foreign banks in Korea, and it is debatable whether this should be considered part of Korea’s liability.

Meanwhile, the fundamental driver of KRW depreciation is reversing. On a full-year 2008 basis, we estimate that Korea will likely record a C/A deficit of 1.2% of GDP, but the trend is more important. Korea’s C/A deficit has totaled an estimated US$15 billion through the first three quarters of the year, but we expect it to swing back into surplus starting this quarter due to the drop in oil prices and reduced imports of goods and services, including overseas travel. In the financial account, the market has been focusing on foreign investment outflows, but we should not forget that Koreans themselves have invested aggressively overseas, and these funds appear to be returning, helping to offset some of the foreign capital outflows.  The external balance, at least, is not worsening.

Nevertheless, market speculation on the KRW may continue until balance of payments data confirm a few months of an improving trend, and such confirmation will have to wait until 1Q09, we think. The only immediate solution to KRW instability, in our view, would be a deal with China or Japan to strengthen bilateral currency swap schemes that could ensure that Korea has sufficient dollar supply.

Bottom Line: Sharp Slowdown in Domestic Economy Rather Than Exports

The problem that the Korean economy is facing is domestic, rather than export-led. While exports will almost certainly slow, we continue to see Korea’s export slowdown as milder than that of other exporters in the region due to its strong competitiveness and cheap currency. Domestic consumption, however, is only at the beginning stage of a longer and deeper correction, we believe, while SMEs depending on domestic demand will struggle to find working capital. Non-performing loans will probably rise in the next 12 months. 

The next policy response will be focused on the real estate market, in our view, and could include aggressive cutting of capital gains tax, lifting of the restrictions on the construction industry and more housing programs to absorb the oversupply. We also expect further elimination of income tax rates in 2009.

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