In a scholarly paper that was released today James Bullard, President of the Federal Reserve Bank of St. Louis, stated, “The U.S. is closer to a Japanese-style outcome than at any time in recent history”. As everyone knows, the Japanese economy has undergone a period of extremely slow growth with periodic recessions combined with price deflation over the past 20 years. Its stock market is still about 70% below the 1989 peak while property values are still depressed despite ultra-low interest rates and massive government spending. While the paper concluded that this was not the most likely outcome, the release caused an immediate intra-day drop in the stock market that was partially reversed later in the session. Bullard’s prescription for avoiding this highly undesirable outcome was to advocate more reliance on additional quantitative easing (QE) rather than extremely low interest rates.
Bullard’s paper is the latest of a recent realization that deflation is a major threat and that the U.S. could follow Japan into its own lost decade (or two?). However, Comstock pointed this out over a year ago in a “special comment” dated May 21, 2009, titled “Deleveraging—-U.S. vs. Japan”. In that comment we wrote– referring to Japan, “Now nearly 20 years later, both the stock and commercial real estate markets remain more than 70% off their peaks, while residential land prices are more than 40% below their peak. Although the optimistic view is that the various stimulative plans by the new administration, together with the massive easing by the Fed, will help the U.S. avoid the same deleveraging result as Japan, it is exceedingly difficult to see how that will happen”.
Although Bullard was expressing his personal opinion rather than that of the FOMC’s, we think it is important. He is a voting member of the FOMC and, more importantly, he is regarded as one its more hawkish members. For a hawkish Fed governor to come out for additional substantial QE could be a turning point in how the investing public looks at the longer-term outlook for the economy.
In our view the case for deflation is a strong one as most of the classic symptoms are present in the U.S. today. Record historic debt is already in the process of deleveraging, and there is still a long way to go. Consumer demand is restrained. There is an excess of labor supply with five people available for every open job. Capacity utilization rates are historically low. Household net worth is far below peak levels. Credit is available only to the most highly qualified borrowers. Money supply has been flat or decreasing despite massive stimulus. All of this is a classic recipe for deflation.
We also believe that there is little the Fed can do to avoid the outcome. Japan kept both short and long-term interest rates exceedingly low for many years and ran massive budget deficits with little to show for it, although they did prevent a complete collapse of their economic and financial system. While there is a difference between the U.S. and Japan, two major differences were in favor of Japan rather than the U.S. During most of Japan’s two-decade malaise the global economy was quite strong and Japan was able to support its economy with a substantial amount of exports. Furthermore, Japan started with a 12% household savings rate and was able to run it down, thereby providing some support for consumer spending.
So far, the stock market has been resistant to a downturn. The consensus believes that the economic recovery is on track, the Fed can avoid deflation, the U.S. is not like Japan, the European crisis is over, the market is cheap, and China has curbed its real estate bubble. For reasons pointed out in past comments, we disagree on all counts and investors are making the same mistake they made in early 2000 and late 2007 when they overlooked key negative factors that should have been recognized at the time.