The coronavirus lockdown has pummelled the US economy, with some 30m jobs destroyed and trillions of dollars of output and wealth lost. Compounding the havoc is an economic malady that has gone unnoticed: one of the most severe deflations in modern history. Unlike coronavirus, it shows no signs of abating.
Prices are tumbling. The March personal consumption expenditures gauge fell at a 7.5 per cent annual rate, while the Consumer Price Index in April fell by more than in any month since December 2008. More worrisome is the trend in commodity prices, the best day-to-day indicator of inflation. We are now seeing a downward price spiral. We know that oil prices have plummeted this year, reflecting a rapid fall in global demand, but the shortage of global dollar liquidity is adding to the industry’s pain. Virtually all commodities are seeing declines. The leading commodity price index, the CRB, is down a third since January.
Or look at the yields on Treasury bonds and Tips (Treasury Inflation-Protected Securities). Louis Woodhill, a senior fellow at the Committee to Unleash Prosperity, notes that the US Federal Reserve’s “target PCE inflation rate is 2 per cent, and the market is betting that PCE inflation will average barely over half that rate (1.1 per cent) for the next 30 years!” Both Mr Woodhill and I have been warning of the damage from falling prices for many months. Our deflation diagnosis may seem surprising because Congress has added some $3tn to the debt and the Fed has injected at least $2.1tn of dollar liquidity into the economy. The central bank has also cut interest rates close to zero. These actions are normally associated with rising, not falling prices.
So how are we experiencing the opposite result? When the world gets hit by a catastrophic event one effect is always a stampede to the US dollar for safety. Americans are hoarding dollars, nervous investors are flooding into cash and foreigners are buying the safest investments they can find: US government bonds, which are repaid in dollars.
Deflation, as we discovered during the Depression of the 1930s, when rapid price declines drove the economy to its knees, is a killer of prosperity. Workers get crushed because real labour costs rise, which shrinks hiring and drives up unemployment. Yet even with every market signal flashing deflation, academics and the Fed are still more worried about inflation. Former Fed governor Larry Lindsey argues in his latest newsletter that there will be a coming inflation when the economy recovers. The inflation hawks may be right, but when 30-year bonds are trading at 1.35 per cent interest rates, the collective wisdom of the market is making a huge bet in the other direction.
Let us assume that the prediction of future inflation, because of all this government borrowing, is correct. This is still not an argument for tolerating the growth-killer of deflation now. If the Fed were targeting commodity prices, it would inject massive dollar liquidity now. As the economy begins to recover, and if commodity prices start to rise rapidly, then it is time to start draining that liquidity. When your house is on fire, you turn the hoses on and worry about the water damage later.
Have Fed chairman Jay Powell’s interventions failed? No. If anything, the Fed has actually been too timid in reacting to the crisis. By refusing to let prices guide monetary policy — much as his predecessor Paul Volcker did while killing the inflation of the 1970s — the Fed is still depriving global markets of the dollar liquidity they are pleading for. If this isn’t corrected, falling prices will prevent the V-shaped recovery that the US and the world desperately need.
The good news is the Fed and the Treasury are far from being “out of ammunition”. They should take the following steps. First, the interest rate that the Fed pays on bank reserves should be reduced to zero (from 0.1 per cent now). Then payroll taxes should be eliminated for the rest of the year (and all those already paid this year by workers and employers refunded) until the deflation abates. This is much more efficient than more federal spending.
The Treasury should also be authorised to swap T-bills for the non-marketable Treasury securities in the Social Security Trust Fund, so that its trustees can sell them and buy common stocks. If this had been done during the 2008 crisis, social security would have reaped a gain of trillions of dollars, based on the rise in US share prices over the decade. Share purchases should be done via an exchange traded fund, so that the government has no corporate voting rights.
If the US economy is to get back to the prosperity of Donald Trump’s first three years in office, it isn’t enough to conquer coronavirus. The Fed and the Treasury must also boldly slay the other invisible killer of growth — deflation.
The writer is a member of Donald Trump’s economic recovery task force and co-founder of the Committee to Unleash Prosperity