13th Nov.

2008

Deflation is coming to town

• Good news for bonds, not so for equities and commodities

• Lower oil prices should have helped to shrink the US trade deficit (13.30 GMT)

• German GDP set to contract again (07.00 GMT)

Key market themes prices and wages that can result from a debt deflationary
Deflation is coming to town. In our latest Global spiral. For now we only expect the first, which should
Inflation Watch published yesterday, we highlight how provide a welcome boost to household incomes and
CPI inflation is likely to turn negative in the US, UK and consumer confidence.
Japan next year. Of the major economies, only the
That being said, in the current circumstances it may be
eurozone is likely to be spared. (See Chart 1.)
hard to prevent a period of falling prices from
CHART 1: CONSUMER PRICES (% Y/Y) developing into something less benign. After all, the
great deflations of the past have resulted from the sort of
7 US UK 7 poisonous cocktail of over-indebtedness and falling
Euro-zone Japan CE
6 6
Forecasts asset prices that we are now seeing. This simply
5 5
4 4
underlines the need for policy-makers to use every tool
3 3 at their disposal.
2 2
1 1 Official interest rates will therefore continue to be
0 0 slashed, while the depth and duration of the global
-1 -1 recession is likely to mean that monetary policy remains
-2 -2
extremely loose for a long time. Next year official rates
04 05 06 07 08 09 10
in the UK and the euro-zone are likely to fall to record
Sources – Thomson Datastream, Capital Economics lows of 1% and 1.5%, respectively, and stay there
Deflation is not always bad news. It is important to during 2010.
distinguish between a relatively short period of negative Of course, the Fed is running out of conventional policy
inflation due to the unwinding of a commodity price options. But just because the US central bank is ahead
shock, and a more sustained period of generally falling of the pack, does not mean it will sit back once the zero

KEY DATA AND EVENTS

GMT Previous Median CE Forecasts
th
Wed 12 Jpn DCGPI (Oct) 23.50 -0.4%(+6.8%) -0.9%(+5.5%) -
th
Thu 13 Chn Industrial Production (Oct) 02.00 (+11.4%) (+11.1%) (+12.0%)
Jpn Industrial Production (Sep Final) 04.30 +1.2%(+0.4%)p - -
Ger GDP (Q3 Prov.) 07.00 -0.5%(+1.7%) -0.2%(+1.0%) -0.3%(+0.8%)
Fra CPI (Oct) EU Harm. 07.45 0.0%(+3.3%) -0.1%(+2.9%) -0.1%(+3.0%)
Ita CPI (Oct Final) EU Harm. 09.00 +0.5%(+3.6%)p +0.5%(+3.6%) +0.5%(+3.6%)
EZ ECB Monthly Bulletin (Nov) 09.00 - - -
Ire CPI (Oct) EU Harm. 11.00 +0.3%(+3.2%) -0.2%(+3.0%) -0.1%(+2.9%)
th
EZ 5 ECB Central Banking Conference 13.00 - - -
US Initial Jobless Claims 13.30 481,000 480,000 -
US Trade Balance (Sep) 13.30 -$59.1bn -$57.0bn -$53.0bn
US Monthly Budget Statement (Oct) 19.00 -$56.8bn -$200.0bn -
th
Fri 14 Chn Fixed Asset Investment (Oct) 02.00 (+27.6%) (+27.4%) (+27.5%)
Spr Retail Sales (Sep) 05.00 +0.9%(+4.2%) +3.4%(+3.6%) -
m/m(y/y) unless otherwise stated; p = provisional estimate
Capital Daily 1
bound for the funds target has been reached. (We expect
a cut to 0.5% next month). In a speech back in
November 2002 entitled “Deflation – Making Sure “It”
Doesn’t Happen Here”, Ben Bernanke spelt out some
potential options. These include “lowering rates further
out along the Treasury term structure – that is, rates on
government bonds of longer maturities.” This could be
achieved either by committing to “hold the overnight
rate at zero for some specified period”, or (Bernanke’s
preference) by the Fed “announcing explicit ceilings for
yields on longer-maturity Treasury debt”, as it has done
in the past.
Of course, one of the key problems today is that lower
official interest rates (and government bond yields) are
not having an impact on the real economy. The Fed
might therefore need to consider whether it made more
sense to buy mortgage bonds or other private sector
securities rather than Treasuries, even if that led to some
deterioration in the quality of its balance sheet.
Deflation, and the policy response that it elicits, should
be music to bondholders’ ears. Our expectation is that
10-year Treasury yields will tumble to just 2.5% next
year. The main reason we are not projecting even lower
yields is precisely because we do not currently expect
deflation to last as long as it has in Japan, where a
structural shift away from seniority-based lifetime
employment has led to persistent downward pressure on
wages over the past decade.
Alas, deflation – particularly if it proves enduring - is not
such good news for equities. The gap between investors’
required rate of return and the expected growth rate of
corporate earnings - which determines the stock
market’s price/earnings ratio - can theoretically grow
unchecked when prices are falling. This is because
nominal earnings continue to decline under deflation,
but nominal interest rates cannot drop below zero. In
the Great Depression of the early 1930s, the P/E ratio on
the S&P 500 dropped to just above 5 according to long-
run data provided by Robert Shiller of Yale University.
The commodity bubble has, of course, long since burst.
Chinese pump priming is unlikely to stop the rot,
judging by the fact that industrial metals prices have
fallen back below where they were trading before the
fiscal package was announced last weekend.
Gold, of course, has stood out a little from the
commodity crowd amid the recent financial turmoil. But
deflation does not augur well for an asset that is
supposed to be an inflation-hedge. We continue to
expect prices to fall to $550/oz. next year. (John
Higgins)
What to watch for today: US
The decline in crude oil prices will cut the monthly cost
of imported oil by as much as $20bn. The initial stages
of that adjustment will be evident in September’s
international trade figures (13.30 GMT). The drop back
in the oil price to just over $100 a barrel in September is
consistent with a $5bn decline in the cost of imported
oil.
There will be a couple of wildcards as well. The strike at
Boeing in September means that the manufacturer only
delivered seven commercial aircraft to overseas buyers,
compared with 20 aircraft in August. The bigger
uncertainty, however, is what impact Hurricane Ike had
on both inbound and outbound cargo. All things
considered, we have pencilled in a decline in the trade
deficit to around $53.0bn in September, from $59.1bn.
Looking ahead to next year, the sharp drop back in
energy prices won’t be the only factor affecting the trade
deficit. The drop back in agricultural commodity prices
will actually widen the deficit because the US is a net
exporter of agricultural commodities, in particular
wheat, corn and soybeans. More generally, the
deterioration in the prospects for activity in other
countries and the dollar’s resurgence will also hit US
exports hard. This could get very grim. The collapse in
the export index in October’s ISM manufacturing survey
leaves it at a level consistent with 20% y/y decline in
real exports. (Paul Ashworth)
Continental Europe
Germany is no longer weathering the global storm and
we expect GDP to fall for the second quarter running in
Q3 (07.00 GMT). The monthly data so far paint a
worryingly picture. On the output side of the accounts,
industrial production fell by 1.3% q/q, a similarly poor
outcome to that in Q2. Meanwhile, the business surveys
suggest broadly flat service sector output. On the
expenditure side, retail sales figures point to unchanged
consumer spending after Q2’s 0.7% drop. But nominal
trade data indicate that export volumes stagnated in Q3
while import volumes rose fairly sharply. GDP looks set
to fall by around 0.3% q/q, leaving Germany in its
second recession in five years. (Jennifer McKeown)
UK
No major events or data releases scheduled.
November’s Bank of England Inflation Report, released
on Wednesday, gave the strongest possible signal that
the MPC expects to cut interest rates significantly further
over the coming months. We continue to expect rates to
head to 1% or below.
The forecast for CPI inflation based on markets’ interest
rate expectations (of a fall in rates to just below 3%)
Capital Daily 2
predicted an inflation rate of around 1% - that is, a full
1% below the 2% target – at the 2 year policy horizon.
Even in the third year of the forecast, inflation is
expected to remain well below 2%. The clear
implication is that the MPC needs to bring interest rates
down much further to avoid a prolonged undershoot of
its inflation target.
What’s more, the fan chart around the central forecast
shows a significant probability (around 15%) of outright
deflation.
Meanwhile, the MPC’s forecasts for the real economy
were also been revised down sharply. The economy is
expected to contract by around 1.5% next year, in line
with our own forecast.
However, growth is then expected to re-accelerate
strongly to around 1.7% in 2010 and to 3.0% in 2011,
implying a much shorter downturn than seen in the
early 1990s. Our view is that the continued effects of the
credit crunch and the likelihood of a prolonged period
of adjustment in the household sector point to a longer
downturn. We still expect the economy to contract by
another 1% in 2010.
All of which points to the need for interest rates to come
down to very low levels and to stay there for a long
time. Admittedly, the Inflation Report forecasts do not
take account of any fiscal loosening in the forthcoming
Pre-Budget Report. But it seems very unlikely that even
major tax cuts will relieve the need for much looser
monetary policy too.
Another cut in interest rates of at least 0.5% at the
MPC’s next meeting in December now looks very likely,
with further moves in the following months perhaps
bringing interest rates down to 1% by the middle of next
year. But like Mr King, we would not rule out the
possibility that interest rates have to fall all the way to
zero. (Jonathan Loynes)
Much worse is to come. The labour market is a lagging
indicator and so does not fully reflect the slowdown in
the economy seen so far. What’s more, the downturn is
set to worsen. We expect the worst recession in 25 years
to push up unemployment (on the ILO measure) to over
3m. Even though it is rising from a much lower starting
point than in the early 1990s, the unemployment rate is
still set to match the 10.5% peak in the last recession.
Meanwhile, we expect the claimant count to reach 2m.
(Vicky Redwood)
Asia-Pacific
China’s industrial production figures (02.00 GMT) are
worth a closer look than usual. In recent years they have
shown very little variation month by month, making
them a poor indicator of the underlying strength of
Chinese industry. But September’s reading was the
lowest since the end of 2001, leaving aside the usual
volatility around Chinese New Year. The controls on
industry around the Olympics were only part of an
explanation, since they were lifted mid-way through the
month. We expect a small bounce back in October, but
the rate of growth will remain weak. (Mark Williams)
In the event, Japan’s consumer confidence survey
released on Wednesday morning was not quite as bad
as might have been feared. Admittedly, confidence fell
in October to the lowest level since the survey began in
1982. However this was little surprise after the worst
month for the Nikkei in living memory. The headline
index for all households fell from 31.8 to 29.8, broadly
in line with consensus, but we had anticipated
something even weaker after the slump in the Economy
Watchers’ Survey reported earlier in the week. More
positively, inflation expectations edged lower again,
confirming that falling gasoline prices are having some
impact. There will be a lot more good news on this front
as headline inflation falls sharply, boosting real
incomes. (Julian Jessop)

October’s monthly rise in the number of people

John Higgins
claiming unemployment benefit of 36,500 was slightly
+44 (0)20 7811 3912
smaller than the consensus forecast of a 40,000 rise. But
john.higgins@capitaleconomics.com
with September’s increase revised up by almost 5,000,
the level of the claimant count still reached 981,000. Published at 16.00 GMT 12th November 2008
The other measures of labour market activity were not Editor: John Higgins
any better. The ILO measure of unemployment rose by
140,000 in the three months to September to over 1.8m.
And employment fell by almost 100,000.

Capital Economics
Managing Director: Roger Bootle
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