Stocks rise amid deflation confusion
2 June 2003
May ended on a high note for investors in the United States. The S&P 500 Index closed at 963.59 on 30 May, its sixth weekly gain in seven weeks and an 11-month high. The Dow Jones Industrial Average rose to 8,850.26, its fourth weekly gain in five weeks. The Nasdaq Composite Index closed at 1,595.91, its highest close since 31 May 2002, and its fourth straight month of gains, the longest stretch since December 1999.
All these gains occurred on the back of an improving economic outlook. The University of Michigan's consumer confidence index rose from 86 in April to 92.1 last month, its highest since June last year. The National Association of Purchasing Management-Chicago's factory index rose to 52.2 last month from 47.6 in April.
30 May was also a good day for Singapore. The Straits Times Index closed at 1,349, its highest level in over four months, and leaving the index in positive territory for 2003 so far. Singapore also went off the World Health Organisation's list of countries affected with Severe Acute Respiratory Syndrome (SARS), which should set the stage for a recovery in its battered tourism industry.
Not all recent news was good, though. The Hong Kong economy contracted a seasonally-adjusted 0.3 percent in the first quarter of the year compared to the previous quarter. Japan's unemployment rate remained high at 5.4 percent in April, its gross domestic product for the first quarter was flat while industrial production fell 1.2 percent in April.
The problem that Japan and Hong Kong are suffering from is deflation. Years of excesses in asset price increases, coupled with the competition from China and the consequent departure of manufacturing jobs to the latter, are taking their toll on these economies. And it is not just Japan and Hong Kong. Many other Asian countries are also on the verge of deflation.
In the west, however, there is considerable debate over the threat posed by deflationary forces. Some economists, including the Federal Reserve chairman Alan Greenspan, think that there is a risk of impending deflation in the United States and other western economies. Some even contend that deflation is already in progress. Others reject such notions, pointing out that official consumer price indices and money supply are still rising.
A middle ground is probably the correct place to be. In my opinion, western economies in general are not suffering from deflation. Not yet, at least. The issue, as Greenspan points out, is the risk of deflation, not the fact. The risk of deflation arises from high debt levels and excess capacity in the global economy. Deflation occurs only when individuals and businesses start to reduce their debt.
The confusion in defining the current situation may have been compounded by the impact of foreign money. Foreign investments in the United States in the late 1990s had kept the US dollar strong despite the US current account deficit. The increased money supply raised domestic prices, including asset prices like stocks and real estate, but the strong US dollar kept the prices of imported goods low. In such a situation, the official inflation rate, as captured by the consumer price index (CPI), may diverge from the rate of growth of money supply.
However, with foreigners now pulling their money out of the US, the effect may be reversed, that is, prices of foreign goods may stop declining -- or even start increasing -- while domestic prices may start to decline. That is when the deflation risk becomes manifest. Again, this may not be fully reflected in the official inflation rate.
A paper last year by Martin Baily, former chairman of the Council of Economic Advisors in the Clinton administration, indicated that a 20 percent drop in the value of the US dollar would reduce the level of real GDP by 1.2 percent by 2007. Personal consumption would drop by more than 5 percent while capital spending would be down nearly 12 percent over the same period. However, the CPI-based inflation rate would be raised by one full percentage point over the next five years.
So in a nutshell, there is essentially one way in which deflation can be kept at bay in the United States, and that is for Americans to maintain their current debt level. The problem for US policy makers now is that foreigners are no longer as willing to provide the funds as in the late 1990s, hence the recent weakening of the dollar. The Federal Reserve will have to keep monetary conditions loose -- the US$330 billion in tax cuts that were recently approved by the US Congress will also help -- and hope that the effects are not negated by further capital outflows.
Of course, ideally, the correct way to prevent deflation is to prevent inflation and excess debt accumulation in the first place. The Federal Reserve missed its chance to do that. It may now have to live with the consequences.
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