Trichet and the ECB: Tard-y

Deflation is not always a bad thing. However, it is very difficult to make a distinction between ‘good’ and ‘bad’ deflation in practice, given the entwining supply and demand shocks. Our best judgment is that the potential deflation that we envisage to emerge in 1H09 will be a mixture of ‘good’ and ‘bad’ deflation, with the former likely dominating the latter.

Here’s why:

First, the potential deflation, or drop in price level on a year-on-year basis, in 1H09 will likely reflect the high base in 1H08. The surge in prices for both international commodities and domestic raw materials in 1H08 has been largely driven by speculative demand, stemming from investors’ need to hedge against a weak US dollar and expectations of further price increases, in our view.

By the same token, the subsequent sharp correction of these prices in a near-freefall fashion since 3Q08 has reflected a massive unwinding of these speculative positions (by commodity investors) and destocking (by commodity users), as the global financial market leveraging intensified suddenly in the aftermath of the bankruptcy of a major financial institution in the US. This is more of a financial market event than a real economic one. From China’s perspective, this is a positive supply shock, in our view.

The ‘bad’ deflation stemming from the two types of negative demand shocks – tight monetary policy in 1H08 and weak external demand – will take a bit longer to show, as suggested by the historical relationship.

Entering 2H09, deflationary pressures may ease, as the positive supply effect will likely phase out. The negative demand shocks will instead become the primary deflationary forces. In this context, whether the headline deflation in 1H09 will persist into 2H09 hinges on policy responses, in our view. Like inflation, deflation is also ultimately a monetary phenomenon. The policy tasks are twofold: i) to undo the previous tightening effect and stimulate real domestic demand with a view to offsetting the external weakness; and ii) to prevent deflationary expectations from getting entrenched, which may set off a deflationary spiral and turn ‘good’ inflation into ‘bad’ inflation. This would entail strong, pre-emptive policy responses, in our view.

The initial deflationary impulse due to positive supply shocks should bring about cost savings, especially to the energy- and raw materials-intensive sectors. However, with sticky nominal wages, we believe that persistent deflation will cause real wages to rise, profit margins to fall and employment to be cut back, which may set off a deflationary cycle with far more serious consequences. A deflationary environment generally favors bond holders (or creditors) over equity investors (or debtors).