Rate Watch #1098 – Inflation, Disinflation, Deflation
August 21, 2017
by Dick Lepre
Some changes in this newsletter: 1) these are now coming from our mail server. Some of you who had not been getting these should be seeing these once again 2) these will no longer include interest rates. If you want to know where rates in general are you can phone or email but the only way you can get an accurate quote is to submit an actual loan application (see the “Get Started” link at the end of this email) because your rate depends on credit scores, property type, occupancy, income, value of property and loan to value ratio, length of time of the rate lock, whether or not values in your area are declining, and cash out (if refinancing).
- I) Fundamentals
A healthy gain in Retail Sales was the strongest thing last week. Data on Housing Starts continued to disappoint indicating that the 10 year period of decreased homeownership is not likely to end any time soon.
A recap of this week's fundamentals is here.
- II) Analysis
Despite most everyone disagreeing I believe that we are headed for a period of lower Treasury yields and home loan rates. This belief is based mainly on the technical forecast provided by Stomaster. In fact within a month or two we will enter a secular bull market (higher prices, lower yields and home loan rates) for Treasuries which will last 12-14 months. This belief is supported by low inflation. I think that we will start hearing more about disinflation (lower rate of inflation) and even deflation. Clearly this is not the Fed’s plan but then again the Fed appears to have almost zero control over the economy. Massive increase in money supply and near zero rates led to puny GDP growth.
III) Advanced Approvals
RPM now offers Advanced Approvals. If you are thinking of making an offer on a home this is significant. Our Advanced Approval gathers your loan application, credit report, income and asset documentation and is given an actual underwriter approval without a specific property. Once this is done you will get a letter saying that you have an underwriter approval for a loan up to a certain amount with a specified down payment. This enables you to make an offer to close in 25 days. The fact that you have a RPM Advanced Approval and can close in 25 days significantly improves the chance of your offer being accepted.
You can now follow my daily posts on the economy on Twitter @dicklepre
III) Inflation, Deflation, Disinflation and NAIRU
Economists and folks in the home loan business spend a lot of time being concerned about inflation. Why? For a moment, instead of being a borrower who is getting a home loan fixed at 4% for the next 30 years think of yourself as the person on the other end of this - the party receiving the monthly payment for the next 30 years. Note first that they don't get the entire 4%. They get just above 3% with the rest going to other parties. Their dread enemy is inflation. If inflation were to increase to 4% the real (inflation adjusted) value of the cash flow would be about -1%.
Institutions have assets (the loans they own) and liabilities (deposits). When there is inflation the value of their fixed rate assets declines and the cost of liabilities (savings rates) increases. Prolonged inflation is risky to banks. Banks pare off rate risk by having third parties assume the rate risk through rate swaps.
Disinflation is a decrease in the rate of inflation. The rate of inflation decreases but its actual value is still positive. If deflation continues CPI could hit and pass through zero and we would then have deflation. Disinflation is a warning signal. It generally signals slowing economic growth.
What Happens in Deflation?
Just how close to deflation is the U.S. economy? Inflation (which hit a post-World War II high of 13 percent in 1979) is running at less than 2% percent. So, it wouldn't take much to transform disinflation - progressively smaller price increases - into declining prices.
Deflation might be a nightmare because we are not prepared for it. Deflation is the opposite of inflation. Prices of goods and services would fall over time. Cash would increase in value. Debt, which was no big thing in times of inflation, might prove fatal to municipalities, companies and individuals. The effective interest rate would rise and defaults might result. This could lead to chaos in banking. Debt heavy companies would feel pressure to cut wages and salaries. Folks with mortgages might not have any income as their jobs disappeared. In deflation, debt is a curse. A retiree on a fixed income would find himself richer each month. One might curse the mortgage broker who got them a 4% fixed rate mortgage. Aarrgh!! My payments are fixed. I have fewer dollars of income. Each month the value of that fixed number of dollars would increase. The value of my home would decrease. Why should I make my mortgage payment? In the first four years of the Great Depression, prices fell an average of 8% per year and big chunks of the economy went down with them.
One reason that the Federal Reserve might fear deflation is the National Debt. Deflation would imply lower price and wages and lower tax receipts. It could be tough to service the $20 trillion National Debt with a smaller tax base and tax receipts. Debt + Deflation = Trouble.
In deflation there is little incentive to invest in plants and equipment. Why invest today if the expense of doing so will be less next year?
An example of deflation killing an industry was Telecom. Large capital investments in bandwidth were made before the dot-com bubble burst some of it with borrowed funds – and the price of bandwidth collapsed. The telecom industry was hurt by its own competitiveness.
Inflation and deflation can be viewed in a historical perspective. In the book "The Death of Inflation," British economist Roger Bootle points out that inflation has been the exception throughout history, not the rule. British studies show that in 1932, prices were slightly lower than they were in 1795. And, according to Bootle, when one looks at prices dating back to the year 1264, 97 percent of all the price inflation in the last 700 years has occurred since 1940. (I am not sure what this implies but it sounds "cool".)
The risk of deflation is not theoretical. It has been happening to Japan since the early 1990’s.
NAIRU (pronounced nay-roo) stands for "Non-Accelerating Inflation Rate of Unemployment." It really means "the rate of unemployment which leaves inflation constant". It was sometimes called the "natural rate" of unemployment. That is an even worse term because it is hard to believe that there is anything "natural" about this.
Lurking behind NAIRU is something called "the Phillips Curve". Having analyzed data from 1861 to 1957 British economist A.W. Phillips published a paper in 1958 that noted that when inflation was high in Britain, unemployment was low. The relationship made sense. At the economy expands to near its "capacity" suppliers, workers and manufacturers figure that they can sell all of their "inventory" at a higher price and inflation results. In a recession, people must lower the price of goods and labor to sell their stuff.
NAIRU concentrates on the unemployment rate as a prelude to inflation. For years it was believed that an unemployment rate falling below 6% would trigger inflation.
Before we trash NAIRU, let's try to understand in what sense there is some truth in it. NAIRU is the inflation-safe rate of unemployment. That is, once unemployment falls to NAIRU and the economy does not slow (i.e. GDP continues to increase) inflation is the consequence. This sounds reasonable and may indicate that NAIRU does exist. But, if it does exist, it certainly is not as large as 6% or even 5%, Remember that, as late as 1993 it was the position of the Fed that NAIRU was 6% or greater. One must give the Fed credit (for the most part) in allowing unemployment to fall 6% without panicking to raise rates.
The fallacy of NAIRU, then, is not in believing in it but in the simplistic notion that it is some quantifiable constant or "fuzzy constant". NAIRU has failed because, clearly, the unemployment rate is no longer a valid predictor of inflation. There have been, I think, a lot of small but contributory factors which have caused the "non acceleration of inflation". Among them are:
1) Weaker labor unions. It's hard to get sympathy from the "I dreamed I saw Joe Hill last night" thing when Joe and the Mafia are controlling casinos in Las Vegas.
2) Employers have discovered that contract and temporary employees do not have the bargaining clout to walk into the boss's office and say: "Hey, I want a raise". In addition, such workers do not get the usual job benefits. "Capitalism is getting meaner," suggests Princeton University economist Alan Blinder. 95% of the jobs added from 2005-1015 were something other than full time W2 jobs.
3) The global economy. No matter how low Domestic unemployment falls the fact is that there is substantial unemployment and excess plant capacity abroad. Low priced products from abroad keep domestic inflation tame both in fact (stuff is cheaper) and implicitly - workers are forced to tame their demands for wage increases for fear of pricing the product of their work above what the international market will allow.
In addition we have seen in the computer software business the importing of skilled, low-cost labor. The work did not go abroad, the workers came here.
4) Technology. Technology has increased worker productivity. The expanding impact of the Internet is providing the consumer with both more information and more competitive prices on things such as cars, books and even mortgages. The internet keeps inflation contained.
Let's assume that NAIRU does exist and that it was once 6% but due to changes in the structure of the economy has fallen below 5%. What has it fallen or near? Should the Fed hike rates out of a belief that 1) NAIRU exists 2) must be not much under 4.5% and 3) a "preemptive" strike against inflation in the form of a Fed funds hike is, if not necessary, at least highly desirable. Or should the Fed leave the darn thing alone until NAIRU makes a better case for its existence.
The correlation between inflation and unemployment is not as strong as it once was or perhaps it was never as strong as believed.
It is evident that the Fed's belief that it needed to raise rates because unemployment was so low is something they are having second thoughts about. My belief is that monetary policy has been rendered ineffective because of bad fiscal policy, overregulation, and lack of investments. The Fed has been subtle in its suggestion that it cannot really do anything to achieve economic growth when the government continues to run $1 trillion plus deficits each year.
Further reading on NAIRU may be found at:
V) Technical Analysis from Jim Grauer
There is no weekly forecast this week because Jim Grauer is on vacation.
Entire stochastic analysis is here https://www.loanmine.com/CustomPage378.x