Judging deflation risk

Are you afraid of deflation? Probably not, and for two reasons. One is that we have not had any experience with deflation for more than 70 years. The other is that because of this time distance, we have no real experience in estimating the conditions under which deflation will prevail.

For many years, the dominant way of thinking was that inflation is purely a monetary phenomenon. If the central bank for some reason "prints too many bank notes", we will end up with "too much money chasing too little goods" and that will force up prices.

However, this simplistic theory ignores another fact, that when increased demand can be met quickly by increasing output, no inflationary pressures will emerge. Only when production cannot keep up with demand, the foundation for inflation is laid. Several institutions, eg. OECD, regularly publish an estimation for how much extra capacity the economy has available. It is commonly referred to as the "Output Gap". For many years, this gap has comfortably been around 2 percent.

In 2008, the Western world saw the fastest contraction of output ever seen. My perception is that Cisco-style production and inventory management combined with a carpet bombing of media coverage of the bank crisis created an extraordinary fear in business managers. As a result, orders were cancelled, inventories were slashed, investment plans were binned, all at a pace never seen before. It is probably fair to assume that managers still have a tendency to act quickly in case of bad news.

As a result, the Western world today has the largest output gap on record. Probably, the economies could increase output by 5-7% before reaching capacity. Add that despite the downturn, the technological progress continues, adding quite a bit every year through new technologies and work routines.

And here we come to the real problem. Despite the economic recovery seen over the past 12 months, the growth speed has not been enough to significant reduce the output gap. It means that despite economic growth, the deflationary pressures remain. On top of that, the intense price competition from Asia continues as strong as ever.

Add now that economic growth is slowing. In the US and the UK, it is a structural phenomenon, as households continue to repair and reduce their balance sheets, killing the much-hoped-for recovery in private sector demand and will continue to do so for the next 4-5 years. Elsewhere, the slowdown appears to be a combination of premature austerity programs and a regular "mid-cycle" slowing of growth.

I do not (yet) subscribe to the double dip view. But the fact that the economic growth is anaemic is enough for the Output Gap to remain wide open. In other words, there is nothing out there that can counter the deflationary forces of having a huge output gap for an extensive period of time. If it continues we will enter a period of negative inflation sometime in 2011

Oddly enough, only the bond markets have reacted rationally to the situation. And they have only reacted to the ever-falling inflation, not to the expectation of a lower future inflation. The stock market has not yet eyed the risk. Caveat emptor.