Is there a US deflation risk? No, says BBVA Compass

There is no US deflation risk, say BBVA Compass economists who urge the Federal Reserve to stick to its current timeline on reducing the bond-buying stimulus program. According to their latest research, the US economy is not at risk of sliding into deflation.

In 2013, the Federal Reserve (Fed) was purchasing $85 billions’ worth of bonds monthly to help boost the economy. Tapering started in December when the Federal Open Market Committee (FOMC) voted to reduce the amount by $10 billion. This has continued each month – now the stimulus package stands at $55 billion per month.

The FOMC decided that as the economy was modestly improving, it was time to start tapering. However, there is one indicator the Fed watches carefully – the inflation rate. It is currently far below its 2% annual target.

Does current low inflation raise US deflation risk?

A national economy with sluggish growth and very low inflation is at serious risk of tipping into deflation. Deflation would undermine long-term economic growth and raise the value of the country’s outstanding debt.

US deflation risk
(Source: BBVA Research)

Some economists have speculated that the Fed may slow down its scaling back of stimulus activities. Economists Kim Fraser and Shushanik Papanyan, both BBVA economists, say the Fed should continue on its current course of reducing the monthly bond buying amount by $10 billion.

In their inflationary research, the two economists wrote:

“Although inflation remains lower than expected, our analysis suggests that the risk of deflation in the U.S. is very low. (The risk has) dropped significantly throughout the first quarter of 2014, suggesting that the current slowing inflation rate is considered fairly transitory.”

They forecast a moderate increase in prices over the next year, but acknowledge that technology will continue pushing prices down in all sectors.

The authors wrote:

“Inflation will stabilize at new historic lows as a result of long-term economic structural changes, such as lower costs of production and labor-to-capital ratios driven by globalization and infiltration of technology.”

Low inflation not linked to deflation in US history

US low deflation risk
The risk of US deflation has fallen considerably this year (Source: BBVA Research)

Historically, low inflation in the United States is not always linked to slow growth, the authors explain. Since 1980, GDP grew by over 2% in the majority of the years when inflation dipped below 2%.

The US deflation vulnerability index has fallen considerably in the first quarter of this year, suggesting that the risk of deflation is minimal.

Even though several price indicators register below-trend inflation, the current slowing inflation rate is a temporary one.

According to short-term consumer price indices, moderate inflation pressure this year will come mainly from energy, shelter and medical care, while food prices rises are expected to remain subdued.

The authors concluded:

“While current inflation remains subdued, we expect prices to moderately pick up through the coming year as transitory factors fade away. Upward pressures arising from medical care, shelter, and energy should lift prices in the short-term.”

“Even still, we expect that inflation will not increase back to the average rate seen throughout the past three decades. In fact, we project that inflation will stabilize at new historic lows as a result of long-term economic structural changes, such as lower costs of production and labor-to-capital ratios driven by globalization and infiltration of technology.”

“Looking forward, the question is whether financial markets and policymakers are ready for another round of low inflation which can potentially lead to lower-than-expected interest rates and profit margins.”

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