Seeing Bottom
We might be riding out of the global deflation spiral.

Mr. Malpass is the Chief International Economist for Bear Stearns.
November 19, 2001, 8:00 a.m.

Combined with the buildup in monetary liquidity in October, this reduction in the demand for liquidity may well be enough to break the deflation spiral. The global recovery cycle has been bowl-shaped (slow and sloping down, slow and sloping up), not V-shaped (rapid down, rapid up). Now we can put more emphasis on the recovery side of the bowl.

Until now, it seemed the the desire for liquidity would outgrow the liquidity additions by world central banks. In a deflation spiral, the central bank doesn't catch up to the rapidly growing demand for liquidity — even through repeated interest rate cuts. The demand for liquidity was rising very fast in 2001 due to the negative impact of the dollar's revaluation since 1996, and the prospect of future deflation. September 11 added economic and political uncertainty as another reason to build cash balances.

It seemed that the central banks would have to make a conscious, explicit effort in order to break their deflation spirals. But there's now the possibility that the rapid rate cuts following September 11, plus the sudden change in Afghanistan, will be enough to break the deflation spiral. Of course, the global economic recovery could be somewhat short-lived (like the October 1998 aftermath) unless central banks follow through by changing the policies that started the deflation in the first place.

Liquidity hoarding (the huge demand for safe, short-term dollars similar to the yen hoarding in Japan in the 1990s) reached a climax (a point of capitulation) in early November in response to anthrax and the expectations for a long Afghanistan campaign. Here are the signs that the deflation spiral has been broken — at least for now:

· The sharp rise into positive territory for the spread between the 2-year Treasury note and the Fed funds rate.

· The rise in several commodity indicators. For example, the Journal of Commerce metals index has risen 7% in the last week, indicating the dollar is becoming less scarce.

· The across-the-board rise in the U.S. yield curve in recent days, a clear break in deflation expectations.

· The breakdown of OPEC's monopoly power due, in part, to Russia's growing relationship with the Bush administration. WTI oil has fallen below the neutral (or market-based) $18 price. The economic importance of Saudi Arabia and the Arab oil producers has been materially diminished — an important step toward a more market-based global economy.

· Extensive coverage of deflation in November from the Economist, the New York Times, and other mainstream sources. Expectations for the global recession have fallen sufficiently.

Since June 2000, there has been increasing damage to the world economy from the oil spike, central-bank tightness, the U.S. policy of an ever-strengthening dollar, and heavy tax transfer out of the U.S. private sector. Now it's time to closely track the repairs under way, as the bearish arguments of recent years (that there would be a dollar crisis due to our current account deficit; that over-capacity would take years to resolve; and that valuations are still too high) quickly lose credibility. Turns out the deflationary spiral was the thing to watch — and it just may be winding down.

Some Caveats
However, there are several reasons to remain cautious about the global outlook:

· Even if the deflation spiral stops getting worse, the world economy still has yet to digest a portion of the dollar's sharp post-1996 revaluation. Some prices have adjusted to the new value of the dollar, but others have yet to adjust. This implies more bankruptcies, higher unemployment, further slowdowns abroad, etc.

· World financial markets have already had a strong rebound. The change in the liquidity outlook primarily offers an opportunity for portfolio reorientation from a deflationary stance to a more normal recession/recovery stance.

· The price of gold remains an important indicator of inflation and deflation. Gold prices have declined $6 in the last week. This appears to be a reduction in gold's safe-haven value (gold spiked after September 11) rather than a signal of deeper deflation. An increase in the gold price is necessary to confirm that monetary policy has finally caught up to the demand for liquidity. Until that confirmation occurs, expect a drawn-out bottoming process for the global economy, with the possibility of falling back into a deflationary downturn.

· Over-capacity persists in many sectors. However, there are several comforts: capitalism is good at handling sunk costs faster than expected; the extent of perceived over-capacity is a dynamic estimate — it grew as the global economy sank, and will recede somewhat once growth prospects hit bottom; the world probably uses up over-capacity faster now than it used to, given the fast depreciation and obsolescence rates in many of the fast-growing sectors.

· The sharp decline in the price of oil may create political problems (Venezuela, Arab states).

· The world economy is still absorbing the negative economic effects of September 11, including shrinking trade, security expenses, and a de-globalization of commerce (reversing one of the driving forces of the 1990s expansion.)

In the very near-term, one should be cautious about the global financial markets. But in the medium- and long-term, world financial markets should react positively to the prospect that the multi-year deflation spiral won't get worse. Again, we just may be seeing bottom.