Why Deflation is Neither Imminent Nor Likely (November 20, 2023)

Concerns over outright price declines seem exaggerated, and the level of public debt means economy-wide deflation is implausible.  

Buzz is building around deflation, but investors should remain skeptical of impending price declines across the economy. 

First, a close reading of recent data suggests deflation concerns so far are exaggerated. Take the producer price index. Headline PPI fell 0.5% in October from a month earlier, the first drop since May and the biggest decline since March 2020. From a year earlier, the metric slowed to a rate of 1.3%. Energy fell 6.5% from September and 9.4% from a year earlier, driving the decline. Without it, the PPI was flat in October versus September and up 2.2% from a year earlier. 

To bet on deflation–where prices decline, versus disinflation, where the rate of inflation falls–is to bet that oil falls. Consider some recent estimates from Goldman Sachs. The investment bank predicts a 2024 average of $92 a barrel for Brent crude, up 12% from current levels. Goldman sees West Texas Intermediate crude trading at $80 or higher next year, up at least 3% from its most recent closing price. 

Underlining the point, data from commodity intelligence provider Kpler shows that global oil inventories have erased the builds of the past two months and stand at their lowest levels since at least 2017. That isn’t to mention geopolitics. Helima Croft, RBC’s head of global commodity strategy, says that while a temporary ceasefire between Israel and Hamas may reduce geopolitical concerns, “the wake-up risk from this six-week conflict remains elevated.”

Second, Walmart’s recent mention of possible deflation is worth putting in context. On the retailer’s earnings call last week, CEO Doug McMillon said that while prices are still up mid-double digits from a year ago, “we may see dry grocery and consumables start to deflate in the coming weeks and months.” Looking ahead to 2024, “we could find ourselves in Walmart U.S. with a deflationary environment,” he said.

But even if goods deflation materializes, it isn’t necessarily enough to spur broader deflation. The U.S. goods-producing sector represents just about a fifth of overall economic output. And recall that economists have counted on goods-price deflation to offset stubborn service-sector inflation (see our Aug. 20 article). McMillon’s comments, then, probably support expectations for overall disinflation more than they portend overall deflation. 

Service-sector inflation remains elevated. Excluding energy services, the price of services rose 5.5% in last month’s consumer price index from a year earlier. The price of a haircut, what StoneX Group director of global macro Vincent Deluard calls his favorite measure of sticky inflation, accelerated to a 0.4% pace in October from September. Deluard notes the category has been rising at a steady 5% year-over-year rate since the onset of Covid. The point: most wage-sensitive services have risen similarly. Deluard extrapolates to say wage growth of 5% suggests an inflation rate of 3-4%.  

There are more reasons to at once appreciate disinflation in many categories while betting that that inflation risk remains skewed to the upside, where price changes are more likely to overshoot the Fed’s 2% target than they are to fall below zero. 

Here are a few. Survey data suggest consumers still see 3.5% inflation a year from now. The St. Louis Fed pegs the probability of PCE inflation exceeding 2.5% over the next 12 months at roughly 80%. The bank meanwhile puts the current deflation probability at 0.00005%. Deutsche Bank economists say the chance of higher inflation over the next five years derived from caps (>3%) and floors (<1%) pricing are stabilizing at higher levels, with the former the highest in about a decade. 

But the most compelling reason to expect persistent above-target prices over deflation may be the level of public debt in the U.S. In a 2015 paper, the International Monetary Fund warned of the perils of price deflation at a time when the U.S. debt-to-GDP ratio was about 100. Now that ratio is 120.

“In a deflationary or low-inflation environment, public finance management becomes more challenging,” the IMF said. “With debt ratios already elevated, a deflationary spiral could propel debt ratios into unsustainable zones.” 

The researchers found that, on average, a “mild” rate of deflation increases public debt ratios by almost 2% of GDP a year, with the impact larger during recessionary deflations. “Recessionary deflations are most dangerous for fiscal sustainability, and authorities should be primarily concerned by such episodes of deflation, in which aggregate demand collapses and growth slips into negative territory,” the researchers warned.

Consider as well a 2021 study by the Penn Wharton Budget Model. Researchers there estimated that the total inflation-adjusted liability of the federal debt falls by 4%, 7%, 13%, and 19% for unexpected inflation of 2.5%, 3%, 4%, and 5%, respectively. A permanent increase in the inflation target to 3% from 2% would cut the real obligation of current federal debt by 7% by 2051, they said. Since that estimate was published, total public debt in the U.S. has grown by 11%.

The Fed is unlikely to explicitly raise its inflation target anytime soon. But if economic data were to break from disinflation to economy-wide deflation, it’s a good bet that the central bank will undertake more drastic measures to fight deflation than it has taken to fend off inflation.