Deflation is a long term threat for the stock market

Price deflation in the U.S. is an issue which attracts attention. For example, the FOMC statement implies very low inflation at a two year horizon. The two-year breakeven inflation rate is negative. As a result, economics blogs are also full of discussions around the near future of the overall price behaviour.  (Despite the explicit FOMC statement many experts expect a period of hyperinflation after two sessions of quantitative easing.) The danger of deflation has been demonstrated by Japan where the quantitative easing did not show any positive results.  

We predicted an extended deflationary period since 2012 five years ago. This prediction was based on a model describing inflation in developed countries as a linear and lagged function of labour force. In 2006, we published a forecast for the U.S. a ten year horizon using the following relationship:  

DGDP(t) = 4.0dlnLF(t-2)/dt – 0.03              (1)                       

 where DGDP is the GDP deflator at time t, and dlnLF(t-2)/dt  is the rate of growth in the level of labour force two years before, t-2. In equation (1), the slope is 4.0 and intercept is -0.03. Using (1) and various projections of labour force we estimated the rate of inflation between 2006 and 2016. Figure 1 compares the predicted rate of inflation with that observed between 2006 and 2010.  The agreement is very good considering the precision of inflation measurements and the labour force projection published by the CBO in 2004.  

For 2011, the model predicts the rate of inflation near 0.4%. The current fall in commodity prices and the deceleration in real economic growth both imply no price inflation in the second half of 2011. Hence, our prediction for 2011 from 2006 seems to be right.   

Between 2012 and 2016, the rate of inflation (as expressed by the GDP deflator) will be negative at the level between -0.5% and -1.2% (2013).  Obviously, the CBO labour force projection at a ten year horizon could not be too precise and actual values of the future inflation rate may differ from the predicted ones. However, the negative inflation trend is a serious and long term danger for the U.S. economy.

Figure 1. Predicted inflation rate for the period between 2006 and 2016 according to the CBO’s (2004) labour force projection.  A deflationary period starts in 2012.  

Deflation in consumer prices is also predicted by the current measurements of labour force. We estimated a similar relationship for the headline CPI. Five years ago the following relationship was obtained: 

CPI(t) = 4.5dlnLF(t-3)/dt – 0.032                (2) 

The time lag of three years (actually 2.5 years) provides the best fit between observed and predicted values.  In (2), the slope is larger than in (1). This difference expresses a larger volatility in consumer prices.  Figure 2 illustrates the agreement between the observed and predicted rate of consumer price inflation between 1960 and 2010.  At a three year horizon one can expect a significant fall in the rate of inflation, down to -4% per year.  This is a great threat for producers, consumers and the U.S. economy as a whole. 

The uncertainty in labour force measurements is directly mapped into high-amplitude fluctuations. These fluctuations represent banal measurement noise and can not be removed without improvements in the relevant BLS methodology and procedures. It is instructive that the largest fluctuations correspond to the years of decennial censuses. The Census Bureau has to smooth the difference between counted and projected population values (so called population controls) and the BLS ignores these steps. As usually, the most reliable readings correspond to the changes with the largest amplitude.

The best way to suppress this measurement noise is to use integral (cumulative) values.  Figure 3 displays the observed and predicted cumulative inflation curves starting from 1965. The predicted cumulative curve is obtained by a progressive summation of values from 1963 and is also shifted ahead by 2 years. There is an almost complete agreement between the cumulative curves for the whole period. The only small deviation occurred around 1993 and corresponds to a sharp drop of the rate of labour force growth as induced by the baseline working age population correction.

Figure 2. Measured inflation and that predicted from the dLF/LF (shifted 2 years ahead). An agreement is observed throughout the whole period with some short fluctuations in labour force potentially induced by the population corrections implemented by the Census Bureau in the census years. 

The predicted cumulative curve is very sensitive to free term in (2). Even the initial difference of 0.0001 results in a tangible deviation from the measured curve after 50 years. Therefore, the value of free term in (2) can be estimated with a good accuracy. It is important that the cumulative curves represent actually measured macroeconomic variables: labour force and price. Inflation and change rate are based on first differences of the original values and thus are much more sensitive to measurement errors.  

Figure 3. Comparison of the cumulative values of the observed and predicted inflation presented in Figure 2. The predicted curve starts from 1963 and is shifted by 2 years ahead. An agreement is observed with a notable change from convexity before 1980 to concavity one after 1980.

One can conclude that a deflationary period will likely start in 2012 and then may extend into the second half of the 2010s. Price deflation is a major risk for the stock market.  

Revised GDP estimates support the model of inertial growth

On July 29, the BEA revised real GDP estimates for the years after 2007. The most important news is:

For 2007-2010, real GDP decreased at an average annual rate of 0.3 percent; in the previously 

published estimates, real GDP had increased at an average annual rate of less than 0.1 percent. From the fourth quarter of 2007 to the first quarter of 2011, real GDP decreased at an average annual rate of 0.2 percent; in the previously published estimates, real GDP had increased at an average annual rate of 0.2 percent. 

These new BEA data strongly support our model of real economic growth. Previously in this blog, we found that real GDP per capita in developed countries grows as a linear function of time. Similarly to classical mechanics, we interpret this linear growth as “inertial” growth. When the population pyramid does not change over time one can write the following relationship for real GDP per capita, G(t):

G(t) = At + C           (1)

Relationship (1) defines the linear trajectory of the GDP per capita, where C=G_i(t₀)=G(t₀) and t₀ is the starting time. In the regime of inertial growth, the real GDP per capita increases by the constant value A per time unit. Figure 1 depicts the evolution of annual increment of real GDP per capita in the U.S. since 1950. The new GDP revision makes the slope of the linear regression line (trend) almost negligible (+$1.9 per year) and thus supports our concept. In 2011, the slope may become negative if the increment is below $432. After the two mediocre quarters in 2011, we would not expect real GDP per capita in 2011 to grow faster than in 2010.  

On June 5 we had a post on the current position of the U.S. economy relative to some long term trend. As a rule, economists consider real growth as an exponential process and see the U.S. economy far below its trend. We compared the trends in real GDP and GDP per capita. The latter should be a linear one. Figure 2 depicts the evolution of both variables between 1950 and 2010 with the new readings between 2007 and 2010.

The real GDP curve has an exponential shape as related to the growth in total population. One can easily observe the current deviation from the exponential trend and blame poor economic conditions after 2007. With the decelerating rate of total population growth we would not expect the observed curve to return to the exponential trend (exponential extrapolation of the previous growth.)  

The real GDP per capita evolves along a straight line. After the revision, the curve falls below the linear trend. It touched the trend with the previous set of GDP estimates. All in all, during the past four years the observed curve returned to the long-term trend and may stay below the trend for a while.   We also presented an exponential trend which has a small coefficient of 0.02. This coefficient effectively makes the line very close to a straight one between 1 and 60. However, the deviation from the (extrapolated) exponential trend will be growing and observations will contradict the hypothesis of exponential growth. 

Figure 1. Annual increment of real GDP per capita in the U.S. between 1950 and 2010.

Figure 2. The evolution of real GDP and real GDP per capita between 1950 and 2010. 

The rate of participation in labor force will not fall

Two years ago we published a post with a model describing the evolution of labor force participation rate, LFP, in developed countries. Among other countries, we presented a prediction for the U.S. Figure 1 reproduces the evolution of observed and predicted LFP in the United States as predicted in 2008. The predicted curve was obtained directly from real GDP per capita (see this article for details). Both curves in Figure 1 almost coincide between 1960 and 2007. The largest deviations are observed in the years of biggest revisions to the LFP after decennial censuses. Therefore, they can be neglected as having artificial character. The predicted curve shows that the LFP should decrease after 2006 - the last year with the LFP estimates available when the model was developed.

Figure 1. Observed and predicted LFP in the U.S. as described in 2008.  Notice the largest deviation between the curves is associated with the years of major revisions to the LFP - 1980 and 1990.

Using the same model we revisited the model and obtained a new prediction for the past four years and also two years ahead. Figure 2 compares the predicted and observed LFP curves in the U.S. The prediction for the years between 2007 and 2010 is excellent. In 2011 and 2012, the rate of participation is expected to stall near 64.5%.

Figure 2. Observed and predicted LFP in the U.S. The years between 2007 and 2010 are well predicted.

Time to buy stocks

Two months ago we revisited our model of the S&P 500 returns where the driving force of the stock market is real GDP.  This quantitative model predicted a negative correction of the S&P 500 level in 2011. As an alternative, we suggested that the Bureau of Economic Analysis could revise its real GDP estimates up. However, the BEA revised the GDP estimates significantly down for the years after 2005. As a consequence of this revision, all empirical coefficients in our model have to be re-estimated. Accordingly, the difference between the predicted and observed level of S&P 500 has to change.

Here, we update our model with the revised GDP estimates and include the advance GDP estimate for the second quarter of 2011.  The monthly closing prices through July 2011 are used. As discussed in our working paper on the S&P 500 index, there exists a trade-off between the growth rate of real GDP, G(t),  and the S&P 500 return, R(t). The predicted returns, R_p(t), can be obtained from the following relationship:

R_p(t) = 0.0054dlnG(t) - 0.03   (1) 

where G(t) is represented by the Q/Q (annualized) growth rate, because only quarterly readings of real GDP are published by the BEA.  In our previous model the slope was slightly larger (0.0064) and the intercept did not change.  

Figure 1 displays the observed S&P 500 returns and those obtained using real GDP. As before, the observed returns are MA(12) of the monthly returns. For the predicted curve, we use the same GDP value for all three months in a give quarter.  Figure 2 displays the predicted curve smoothed by MA(4). This smoothed line stresses the mid-term deviation between the curves. 

The period after 2003 is relatively well predicted. The updated GDP estimates highlighted two strong deviations from the observed trajectory started in November 2009 and October 2010. During the first excursion, the predicted curve returned to the observed one in May 2010. One might speculate that this excursion was caused by the first quantitative easing. In any case it was a transitory deviation. 

The current deviation may have the same transitory nature but it is not over yet. In June, we expected this deviation to disappear in 2011. For the current estimates of real GDP, the level of S&P 500 has to be around 1250 in October 2011 in order to intercept the predicted line (see red diamond in Figure 2). Currently, the S&P 500 is below 1200 (the fall we forecasted in June) and thus one could buy stocks. However, the long-term growth does not exclude short-term falls due to the extremely high volatility of the stock market and one can wait for a deeper local trough. 

Figure 1. The observed S&P 500 returns and that predicted from real GDP. For a given quarter, all monthly values of the GDP growth rate are equal.

Figure 2. The predicted curve is smoothed by MA(4). The S&P return prediction for the next three months is shown by red diamonds.

US in liquidity trap?

I have re-read the FOMC statement. Its wording is somewhat contradictory and in some points is very similar to the set of conditions defining so-called liquidity trap. 

“To promote the ongoing economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent.” 

There are two statements in one sentence. The Federal Reserve has to keep the rate low in order to galvanize the economy. In turn, the economy did not show any reaction to the low rate during the past three years and is not expected to grow another two years:    

“The Committee currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.”  

 To keep inflation in the target range one needs to be flexible and to have an opportunity to react when inflation expectations alter.  The rate fixed between 0 and ¼ percent is not a medicine any more. It can not counteract inflation rise because it is fixed. It can not counteract liquidity trap because the rate can not be negative. Hence, the Federal Reserve should not mix economic growth and inflation in one pot. This statement is self-contradictory and reveals a trivial misunderstanding of economics.  

All in all, the Federal Reserve admits that it has failed to improve real economic growth by near-zero rates and by pumping money into banks through the QE mechanism. Moreover, the FOMC does not see any real improvement at a mid-term horizon. Considering the experience of Japan who has been struggling through a liquidity trap for decades one may suggest that the U.S. is already in the trap and all current efforts are worthless.

FOMC has announced a new recession period

I do not understand the euphoria of the stock market participants yesterday. Formally, the FOMC has admitted that the US economy is sinking into a new recession period which will likely end in 2013:

“… The Committee currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013…”

There is no prospective of any economic recovery any time soon and deflation knocks the door. As we have shown in this blog the rate of unemployment will not fall below 9% with employment/population ratio fixed at 58%.

The market players should get to the point during the today’s session and the S&P 500 will be fall again.

Is gold a new bubble?

Gold price rockets up as a natural haven during the turbulent financial markets.  It is reflective type behaviour from the past when gold played a very specific role in finances. Currently, gold is a normal commodity with its price fully driven by the market. Therefore, the rocketing gold price likely repeats the trajectory of house prices before 2006. Some experts say that it was a bubble in sense that the house prices were speculative. Gold can not be an exclusion from  "normal" market behaviour . When the market players understand this simple rule the price will plummet down. I expect this fall in 2011 because the negative tendency in economic performace has no alternative and there is  no really safe haven for assets.