“[T]here is an especially pernicious, albeit remote, scenario in which inflation turns negative against a backdrop of weak aggregate demand, engendering a corrosive deflationary spiral.”
—Alan Greenspan, July 15, 2003

“The Committee judges that, on balance, the risk of inflation becoming undesirably low remains the predominant concern for the foreseeable future. In these circumstances, the Committee believes that policy accommodation can be maintained for a considerable period.”
—FOMC release, September 16, 2003

Here is a financial market syllogism: All fixed income investors watch the Fed. The Fed is watching deflation. Thus, all fixed income investors are watching deflation.

For people who lived through the great inflation of the 1970s (do you still have your “Whip Inflation Now!” button?) and the subsequent inflation-slaying heroics of Paul Volcker, it may come as a surprise to find out that all along the evil that central bankers really feared was not inflation but its even more evil twin, deflation. Indeed, the deflationary pull of a number of conditions—the persistently weak US and global economy, the benign neglect of the foreign exchange value of the US dollar, sagging price indexes, record-low interest rates and the structural imbalances of the international trade, capital and budget positions of the US—are raising the worry level of normally sober central bankers and economists around the world.

The Bank for International Settlements, which sets the global standard for sobriety as the central bank for central banks (among other things, it sets capital standards for banks around the world), described what it had observed in its latest Annual Report, published on June 30. “A general phenomenon…was that goods prices either fell or rose much less than the prices of services. Increased international competition and productivity differentials presumably played a leading role in this change in relative prices, and probably had a broader disinflationary effect as well. One background factor supporting the maintenance of low inflation in the industrial countries was an increasingly firm set of expectations, after some years of low inflation that similar conditions would prevail well into the future.”

The BIS can’t do much more than observe. It is up to policymakers within each country to do something about it, and for them the current debate can be divided into two issues: Defining the problem, and defining the solution. Business and economics textbooks are nearly unanimous in their definition of deflation, along the lines of the following: “A sustained fall in the general price level,” (The MIT Dictionary of Modern Economics, 1992). While falling prices is a true observation in periods of deflation, many would argue that the falling price levels are merely the symptoms of deflation and not the cause. More specifically, the cause of deflation is generally agreed to be an increased demand for money that isn’t offset by an increase in the money supply, or a drop in the money supply that isn’t offset by a fall in the demand for money. To state it another way, deflation makes money more valuable: as prices fall, your dollar (or euro or yen) buys more. Think of deflation as an increase in the exchange rate of your currency against goods denominated in your own currency. (Just to complicate things further, disinflation is a decline in the rate of increase in prices, while reflation is an increase in the rate of increase in prices.)

If we stop to think about it, deflation would seem to be a pretty good thing if you are a consumer. Virtually by definition, goods are cheaper and, if you are a corporate treasurer, as the price of replacing assets declines, more funds become available for other pursuits, such as research, marketing or paying dividends. If consumers put off consuming as they wait for prices to go lower, they will be saving or paying down debt, activities that would portend greater growth in the future. If you are trying to sell goods and services, deflation is potentially problematic if you are unable to lower your cost structure. Thus in the short run, deflation provides an incentive to reduce expenses and invest, while providing a disincentive to borrow. (A debtor is hurt by deflation, as the assets securing the loan will decline in value.) If a company’s cost structure is too high by virtue of improvements in technology, then deflation becomes a cyclically short downdraft. Economist A.Gary Shilling, who wrote a prescient book on the subject in 1998 (Deflation; Why It’s Coming, Whether It’s Good or Bad, and How It Will Affect Your Investments, Business, and Personal Affairs), calls this "good deflation," where prices fall because new technology results in improved productivity and excess supply. As he wrote more recently, “This was true in the late 1800s, when the Industrial Revolution and railroads created tremendous productivity growth and excess capacity. The US grew an extraordinary 4% per year in real terms between 1870 and 1896, as wholesale prices fell 50%. Similarly, the Roaring Twenties were deflationary, as electricity and autos spread. Today’s new technology will sire another era of good deflation. But it won’t seem that way at first, since deflation is arriving in the midst of a recession.”

So what’s all the fuss about? Why did the Fed throw down the gauntlet when it published a discussion paper in June 2002 called “Preventing Deflation: Lessons from Japan’s Experience in the 1990s“? Why was the newest Fed Governor, Ben S. Bernanke, let loose on the markets as the designated deflation hawk with his seminal November 2002 speech entitled “Deflation: Making Sure ‘It’ Doesn’t Happen Here”? Why is the Fed worried about zero inflation in an economy that just turned in 3.1% GDP growth in the second quarter and is poised (according to many if not most economists) for higher growth going forward? Here’s why: Because it could happen here, if it does it likely won’t be benign, and monetary policy may be inadequate to stop it. It is like the old saw about dehydration during exercise: Once you get thirsty, it’s already too late to do anything about it. Consider this statement by Alan Greenspan in a speech delivered to an IMF conference in Berlin on June 3, 2003: “So far as the issue of deflation is concerned, the issue we are concerned about is not the issue of deflation in the sense of falling prices per se, but the issue of corrosive deflation, that is a deflation that essentially feeds on itself, creates falling asset prices, which in turn brings down levels of economic activity through the wealth effect, contracting profit margins and a type of weakness which we all at least theoretically conclude is far more of a concern than inflation….It’s a difficult job to contain inflation, but we’re not all that uncertain about it as we are with the issue of deflation.”

Yes, deflation can indeed be corrosive, and the Fed’s fear is that even though the chances of it happening are remote, it is easy to construct a plausible scenario in which it takes hold and doesn’t let go. And that is a scenario that no Fed chairman wants to countenance on his or her watch. At the same time, while we may have GDP growth in the country, there are nagging problems on the downside. Prices have been slipping: The so-called core rate for consumer prices in the US (which excludes the more volatile food and energy prices), rose just 1.3% year over year, the smallest year-over-year rise since 1966. Employment is weak: The unemployment rate stands at 6.1%, the highest since the recession of the early 1990s. Furthermore, about 1.3 million jobs have been lost since the current recession officially ended in November 2001, the first time jobs have been lost during a recovery. Industry is weak: Industrial production rose 0.1% from July to August and is struggling to stay positive. Capacity utilization, at 74.6%, is stuck at 20-year lows.

Deflation caused by excess supply in the face of weak demand, or excess capacity in the face of a weak manufacturing sector, requires a painful destruction of that excess. Just to give one example, the Wall Street Journal noted recently that global vehicle manufacturing capacity of more than 80 million units per year exceeds global demand for cars and light trucks by about 20 million units per year. It is no wonder that car companies are slashing prices and offering huge incentives to boost demand. Moreover, the cost-cutting on the part of companies leads to a persistently weak employment picture and an uncertainty about the future that retards growth. The weak employment picture is a source of dissent on the rosiness of economists’ predictions for future growth. “Until you see job growth, this recovery has to be considered suspect,” said Pimco’s Paul A. McCulley recently.

Some would argue that the weak employment picture is the essence of productivity. The irony of the current situation is that Chairman Greenspan, the champion of the productivity miracle of the last decade, is so apoplectic about deflation. When he was extolling the virtues of increased productivity, he sounded like Murray Rothbard, the paragon of the Austrian School of economics. Rothbard looked at deflation differently, saying, “rather than a problem to be dreaded and combated, falling prices through increased production is a wonderful long-run tendency of untrammeled capitalism. The trend of the Industrial Revolution in the West was falling prices, which spread an increased standard of living to every person; falling costs, which maintained general profitability of business; and stable monetary wage rates—which reflected steadily increasing real wages in terms of purchasing power. This is a process to be hailed and welcomed rather than stamped out.” Greenspan and the FOMC can’t have it both ways, but to a worker who has been downsized because his company has production capacity that exceeds demand, there is such a thing as too much productivity.

Forcing an economy to reverse any cyclical extreme is painful (e.g., Paul Volcker’s heroic crushing of high inflation in the early 1980s), and this will be no different. But if Japan has taught the American central bankers anything, it is that a central bank cannot stimulate demand simply by cutting interest rates, that monetary policy works much better as a brake pedal than a gas pedal. As the graph below points out, even though the Federal Funds target rate has been cut to 1%, commercial lending activity is in decline.

Inasmuch as Japan is out there as an example, the discussion of whether falling prices should be welcome in a capitalist society is a necessary one, but it is beside the point right now as the Federal Reserve has come out and said that beating it into submission is its number one priority. As investors, we must contend with the other issue in the deflation debate—how the Fed is defining the solution. For that, we take Fed Governor Bernanke at his word when he famously stated, “I am confident that the Fed would take whatever means necessary to prevent significant deflation in the United States… .” The cures that the Fed has discussed publicly could include cutting the Fed Funds rate as low as necessary for as long as necessary, suppressing long-term rates through open market purchases of long-dated Treasury or other fixed-income securities, or by shepherding a dollar devaluation.

More extraordinary measures may be necessary because the possibility exists that reducing the Fed Funds rate may not be enough. Economists from the Federal Reserve Bank of Dallas explained recently that “Policy-makers can find themselves in serious trouble if they come up against the zero interest-rate bound during a period of falling prices—that is, during a period of deflation. That’s because what ultimately matters to households and firms is the real cost of borrowing…[E]ven a zero nominal interest rate can produce an expected real interest rate that is too high if people expect a negative inflation rate.” In other words, if we go back to the proper definition of deflation, what the Fed will do—by hook or by crook—is try to reduce the value of the dollar relative to goods denominated in dollars by increasing money supply relative to money demand (by flooding the banking system with cheap liquidity or turning on the printing press), or increase the demand for money (by lowering its price, i.e., interest rates or exchange rates) relative to money supply. Low interest rates have helped the demand side of the problem for the consumer by spurring increased mortgage refinancing activities, and the federal government is hoping for a fiscal solution to the demand side of the problem in the form of the recently enacted tax cut.

The slow devaluation of the dollar (see our “The Dollar Riddle,” August 7, 2002) is an outcome that could provide inflationary impetus to the economy, and we are starting to see this unstated policy being put into effect. The news coming from the G-7 meeting in Dubai last week is a signal that the stewards of the US Dollar would not mind seeing it weaken in value, versus the Asian currencies in particular. Dollar weakness would generally help the US economy in the short run, but continued and persistent declines in the US dollar would have a negative effect on the US economy and the value of dollar- based financial assets. Foreign investors and economies would put some kind of floor under the dollar since they have more to lose by a weak dollar than we do, but it would take substantial capital flows to support it. The ramifications of a weak dollar policy, then, will be deflationary pressures leading to inflationary ones, weakness in financial assets, and continued downward pressure on short-term rates and upward pressure on long-term rates.

A devalued dollar will have global repercussions, not least in the appetite of foreign investors for dollar-denominated assets, particularly Treasurys and Agencies. To date we have seen nothing to suggest that foreign investors are unwilling to continue funding our twin deficits. According to UBS, once the Treasury debt held by the Federal Reserve itself is backed out, the proportion of Treasurys owned by foreigners rose to 46% at the end of the second quarter. The graph below indicates that foreign investors continue to hold our government securities. At September 18, foreign official institutions held a total of $964.5 billion in Treasurys and Agencies, a $160 million or 19.3% year- over-year increase. Of that amount, Treasury holdings totaled $774.8 billion, an 18.6% increase over the prior year, and Agency debt stood at $189.7 billion, an 21.9% year- over-year increase. We are under no illusions that this is a permanent condition in global monetary affairs. If the Asian central banks follow the directions of the G-7, sponsorship of US Treasurys could decline because these central banks keep their currencies from rising by selling their currencies and buying dollars, which are then invested in US Treasurys and Agencies. The outcome of this constituency voting with its wallet would be for dollar-based investments to offer more attractive prospective returns—which means cheaper stocks and bonds.

More recently, the Fed has added a second, related, concern to its public discussions. Namely, it is increasingly preoccupied with how it communicates its intentions with regard to monetary policy and, by extension, its potential policy initiatives with regard to fighting deflation. Whatever its impetus—fighting deflation or inflation, meeting a target for monetary growth or guiding credit growth—what the Fed does with the one little interest rate it directly controls is of tremendous importance to investors who must contend with the shape and level of the yield curve for their profitability. As St. Louis Fed President William Poole pointed out, the primary determinants of interest rates are the real rate of interest, expectations for inflation, and “a risk premium for unexpected inflation.” To the extent that the Fed can guide the outlook for inflation, either expected or unexpected, it will affect interest rates. And right now, the Fed is letting the market know two things: First, it is afraid that a corrosive deflationary spiral is possible and second, that it will do whatever it takes for as long as it takes to avoid it. The fear of the market is that the Fed’s ability to stimulate economic activity after a downturn is not terribly effective, likening it to “pushing on a string.”

We realize that predicting the future of interest rates is a no-win game, and directional investment bets have a tendency to backfire. Thus, we try not to take any. In the meantime, we continue to monitor the economic statistics, including industrial production, the dollar exchange rate and federal budget data. We watch the monetary aggregates to determine if there is any predictive information in their growth rates. We look at bank lending statistics. Most recently, however, we have been contending with the lower long-term rates that have come about as low-growth, deflationary expectations took hold in the market, and now we are managing through the transition to somewhat higher rates as the market adjusts to new facts and Fed jawboning. All other things being equal, lower long-term rates meant compressed spreads for spread investors and higher refinancing rates for mortgage investors, while higher long term rates are now reversing those effects. Given the Fed’s preoccupation with staving off deflation, however, we feel confident that monetary policy will remain accommodative for some time, and that its efforts—combined with a weaker dollar and the federal budget deficit—will keep the yield curve steep.

September 25, 2003
By Jeremy Diamond, Executive Vice President
Annaly Mortgage Management/FIDAC

This commentary is neither an offer to sell, nor a solicitation of an offer to buy, any securities of Annaly Mortgage Management, Inc. (“Annaly”), FIDAC or any other company.

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