Detect Signs of Deflation from Cause and Effect

Darson Chiu

          The US economy is firmly believed by the market as the one and only that has been on the right track of recovery. However, its Q2 GDP growth y-o-y stood at only 2.3% lower than market expectation. The main reason of why US economic upturn was not as strong as estimated ought to be the appreciating greenback causing the exports to slow down. The economy of Euro zone, not as solid, has been improving as well. The zone's Q2 GDP increased by 1.2%, which was incredibly the highest quarterly y-o-y growth for the past 4 years. The quantitative easing (QE) measure adopted by the European Central Bank (ECB) was just not enough to cope with the rooted debt and structural unemployment issues. After 4-consecutive-quarter decline, the Japanese had the first positive growth in GDP with 0.7% growth rate in Q2. The quantitative and qualitative easing measure (QQE) operated by Bank of Japan (BOJ) has been devaluing Yen and picking up export momentum, but it also imposing heavier burden on import costs. Continuous trade deficits have also slowed down Japan's escalation trajectory. In a quick summary, the advanced world has been performing not strong but fair so far.

          The noteworthy part should be the recent downturn of Chinese economy and China's sudden turn on its monetary policy. Cooling Chinese economy weakens world demand, and the fiasco of its equity market makes the world capital market to shiver further. The negative impacts associated with the state of world economy were on Taiwan's external demand as well as its stock market. As the economic conditions are getting worse, we might wonder if the deflation has betided Taiwan.

          According to the government's most recently issued statistics, Taiwan's consumer price index (CPI) for July declined by 0.66% on a year-on-year basis. This is a 7-month consecutive fall of CPI. Continuously descending price levels could be a negative sign for business outlook. In addition, all forecasting agencies, international and domestic, have downward revised their forecasts for Taiwan's GDP growth of this year. Has deflation really betided the economy of Taiwan? In theory, deflation is a contraction of economic activities resulting in an incessant decline of prices, and deflation is much related to deteriorating economic conditions such as a liable occurrence of recession and high unemployment. If the deflation has been hitting Taiwan, much stronger doses of policy measures in response ought to be used for treatment in no time.

          Both deflation and its opposite, inflation, are a monetary phenomenon. Deflation is in general caused by insufficient supply of money, so it is sensible to examine the origin of deflation by looking into the central bank's monetary aggregate M2 annual growth rates. The M2 growth rate in July this year stood at 6.06%; it was 5.63% in July last year. By comparison, M2 growth rate of each month this year is by and large higher than that of the same month of 2014. Therefore, the money supply was not lacking meaning the cause of deflation should be absent. From the monetary standpoint, the major reason forming deflation has not yet existed.

          Furthermore, deflation normally leads to increasing unemployment due to sluggish businesses. Referring to the government statistics again, Taiwan's unemployment rate in July this year stood at 3.82%, which was even lower than the rate sometime before the most recent global financial crisis. The unemployment rate on average from January till July this year was at 3.70% that was not only lower than the same period of last year but also the lowest reading for the past 15 years. From the readings, we can be certain that the recovery of Taiwan's job market has been on the right track. For that reason, the result caused by deflation has not been present, either.

          Since neither cause nor effect of deflation has sustained, what on earth has been driving down the price levels? Fingers are pointing at crude price plunge since last year. In terms of West Texas Intermediate (WTI), the oil price per barrel was US$ 106.07 on average in June 2014. However, it was priced at US$ 45.25 approximately in early August 2015 indicating a 57% of price plummet during 13-14 months. Actually the crude oil price per barrel went back up at around US$ 60 during the second quarter of this year. Many believed that the price levels were about to mount at that time; however, only just existing and new causes have dragged down the oil prices again.

          The most critical cause making the oil prices to drop is supposed to be the stronger greenback. Janet Yellen, the Fed chair, has already announced in public that an interest-rate hike would certain take place sometime this year. Although the recent weakening RMB could consequently postpone Fed's tightening schedule due to potential perturbing of expanding spread, the overdue timing should still be later this year. As a result, the dollar has been continuously appreciating. All commodities including the crude oil are denominated by the US dollar. A stronger dollar has in due course made the oil prices decline. Besides, the slowdown of China's economy and oversupply of oil from OPEC member countries are also great contributors to the crude price plunge.

          Lower prices lower the value of outputs this year as compared to that of last year. Despite the fact that the quantity of outputs did not reduce as significantly so far this year, the declining value make the economic readings look extremely awful. In a nutshell, it is all about the base effect, since the statistics are calculated on a year-on-year basis in general. When can we pass by the twisted base effect? The effect will subside when the crude oil prices start to go up again, at least reach the level of last year on average. That stood at US$ 93.17 of WTI crude oil per barrel. And the oil price of this year is very unlikely to attain such level; therefore, the base effect will continue to haunt Taiwan's economy throughout the entire year.

          The consecutive fall of CPI y-o-y is improbable to bring to a halt in the near future, and the fear for deflation is expected to arise with worsening economic readings. Some has suggested raising the prices so as to promote economic activities and cope with the downturn. Frankly, I do not believe such measures are even feasible. When consumers and investors are expecting prices to go down, they tend to halt their consumption and investment at present. Therefore, a price hike suggestion targets at turning around the expectation of cheaper goods and services. Theoretically, it seems sensible. However, we should not forget that prices are driven up or down mainly because of two forces, demand pull and cost push. If the measure is about pulling up demand by increasing income, more economic activities will take place. If it's only about cost push, consumption and investment will not happen. That means a simple price-hike policy would not help pick up growth; income effect with profit sharing would do.

          From either the cause or effect perspective, we may conclude that deflation has not yet betided Taiwan. However, a dread of deflation originated from the base effect has caused negative impacts on the current state of Taiwan's economy. The economy has slowed down by far from recession. Expansionary stimulus measures are not needed at this moment; they take two to three quarters to take into effect. By then, the economy might have already passed by the bad times. In addition, price hike policies are not recommended to address the deflationary anxiety. Because policy makers might be thinking about pulling up demand, their policies such as raising water rates and taxi fares can only push up the cost.