Keeping an eye on the three pillars of disinflation

Disinflation, or the slowing down of price inflation, can be a good thing. It can prevent the economy from overheating.

However, when inflation hovers near zero, it may tip the balance towards deflation, which can wreak havoc on the economy with falling prices. Disinflation may also be a harbinger of economic depression.

Winnie Cisar, CreditSights Global Head of Strategy, has stressed the importance of monitoring this incipient trend in the US.

Speaking before Metrobank clients in a webinar titled “2023 Mid-Year Economic Briefing: Opportunities amid growth headwinds”, she cited three pillars of disinflation to watch out for.

“First is the shelter cost lag. Second is the material decline in the money supply that we’ve seen over the past 12 months. Last is the tightening of credit conditions by banks, especially for regional banks,” she said.

“We’ve been highlighting these three key pillars of disinflation that we expect to become more prominent in the second half of 2023.”

Shelter cost lag

Cisar said CreditSights, one of the world’s leading credits research companies, has created scenarios for the trajectory of the core Personal Consumption Expenditure (PCE) deflator, a measure of inflation that excludes volatile food and energy prices.

“We’re sticking with our base case of a gradual return to an average that includes both the slow inflation period of 2011 to 2019 and the elevated inflation of the more recent years,” she said.

“This puts inflation back to 2.5% by the middle of next year. We do see a risk scenario that inflation could finish the year around 4% if more recent trends for the past three years hold.”

She also pointed out that CPI shelter, or the portion of the consumer price index that measures housing and shelter-related costs, “has tracked home prices with an 18-month lag quite well.”

Material decline of money supply

Cisar said the US Fed appears to continue with its quantitative tightening (QT) and that the prepared remarks of policymakers “indicate no real concern about QT continuing in the background at its current pace.”

QT, or the policy action that reduces the money supply in the system to curb inflation, combined with the US Treasury rebuilding its cash balance with the upcoming T-bill supply, had investors worried.

“Right now, we see those concerns as somewhat overblown and unlikely to cause the Fed to change course with respect to QT. In general, we see the liquidity of cash in the system as quite ample,” she said.

Tightening of credit conditions by banks

Elevated interest rates were partly responsible for the bank runs that brought down the likes of Silicon Valley Bank and First Republic Bank earlier in the year.

Corporate clients were discouraged from borrowing and instead utilized their cash parked in deposits. Regional banks, on the other hand, had to fund these withdrawals by disposing of lower-yielding investment securities at massive losses.

Customers’ fear of losing their entire deposits exacerbated the bank runs further and only made it more difficult for banks to lend out any remaining cash.

This tightening of credit conditions is, in a way, just what the Fed needed, as the limited access to funding could bring about a slowdown in investment spending. But the central bank may have to closely monitor the health of the US banking system, especially after Moody’s downgraded 10 small- to medium-sized banks and put six large banks on review.

The ratings agency cited pressures on profitability, exposure to non-performing commercial real estate, and risks to these banks’ ability to generate sufficient internal capital.

A dose of pragmatism

With what these three pillars of disinflation are telling us, cautious optimism seems to be the overarching theme.

Despite economic uncertainties, US households’ excess savings are still estimated to be above USD 500 billion, according to Cisar. Combine that with an intact labor market, and we see that the consumer has fueled the economy in the first half of the year.

We also see an elevated cash balance of companies, giving them financial flexibility to navigate the economy.

“We remain pragmatic in our outlook for the Fed, US growth, and inflation. And US corporate credit is a solid opportunity even with the mix of headwinds and tailwinds,” said Cisar.

(With input from Earl Andrew A. Aguirre, Metrobank Markets Strategist)

ANTHONY O. ALCANTARA is the editor-in-chief of Wealth Insights. He has over 20 years of experience in corporate communications and has a master’s degree in technology management from the University of the Philippines. When not at work, he goes out on epic adventures with his family, practices Aikido, and sings in a church choir.