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Deflation — a sustained drop in prices — is not good news

Imagine a world where prices of all sorts of goods and services just keep moving down.

Your weekly grocery bill shrinks. Your hairstylist gladly accepts 15 percent less, just to get the business. At long last, movie theaters even stop gouging you on popcorn.

Good times? Sure — until your employer cuts your salary or fires you to cope with the need to reduce prices. Suddenly, the economy is in the grip of a vicious spiral, as falling consumption forces prices lower, driving unemployment up, which in turn drives consumption and prices down further.

That's the deflation scenario that has, yet again, become one of the hottest topics on Wall Street.

Fear of a broad-based, sustained decline in prices — the textbook definition of deflation — was rampant at the height of the credit crisis in late 2008.

That concern faded last year as the economy and financial markets recovered. By early this year, many big investors were warning of the opposite risk: They saw the continued ballooning of government budget deficits, and central banks' easy-money policies, as setting the scene for an eventual surge in inflation.

Now, we've come full circle: With U.S. economic growth clearly slowing, deflation worries have revived.

"The U.S. economy is at the doorstep of deflation," Nomura Securities economist Zach Pandl warned clients in a lengthy report this month.

A number of Federal Reserve officials have echoed that concern in recent weeks, although in the usual Fed manner — i.e., without using an alarmist tone.

For the moment, however, the story still is one of disinflation rather than deflation. Prices overall are rising, but the year-over-year rate of increase has fallen sharply since August 2008.

The government's consumer price index for June showed that core inflation — prices for everything except food and energy — was up 0.9 percent from a year earlier, the slowest pace in 44 years.

So what? If you have a job, plenty of cash and relatively little debt, deflation would be paradise. Many of your favorite things would cost less. What could be better?

If you're heavily in debt, however, deflation would make that load even more onerous.

What's more, the deflation scenario terrifies companies, governments and central bankers because it raises the possibility of a downward economic spiral that can't easily be reversed.

If consumers adopt a deflationary mind-set and figure that prices will only get cheaper if they wait to buy, they'll probably be right. But the end result could be a recession even worse than the one we just climbed out of, if demand sinks and companies react in part by slashing their payrolls again.

That is why deflation and depression often are mentioned in the same breath in economic discussions. From July 1929 to March 1933, as the Great Depression deepened, U.S. consumer prices plummeted 27 percent.

If we look to financial markets today for guidance on deflation risks, the messages aren't encouraging. U.S. stock prices have tumbled since April, when worries about the economy began to intensify. Rally attempts have just given way to more selling, as illustrated by the Dow Jones Industrial Average's recent cycle of days of sustained gains leading to a big selloff.

Gold, considered the classic inflation hedge, has fallen 5.5 percent since reaching an all-time high in mid June.

And the one asset likely to be coveted in a deflationary period — Treasury bonds, with their guaranteed interest — has seen ravenous demand for the past three months. The 10-year T-note yield has fallen below 3 percent in recent weeks for the first time since April 2009.

Still, many economists remain convinced that the U.S. won't slide into deflation, because they expect the recovery to continue, though at a slower pace.

Tom Higgins, economist at money manager Payden & Rygel in Los Angeles, expects consumer and business demand to be strong enough in the second half of this year to stabilize annualized core CPI inflation in the 0.7 percent to 1 percent range.

If he's wrong about that bottoming in the inflation rate, Higgins said, "Then we get more worried."

The other major argument against deflation taking hold is that the Federal Reserve will do whatever it takes to make sure it doesn't happen.

That would probably mean printing money with abandon and figuring out ways to get that cash into the hands of businesses and consumers if banks can't or won't.

Wouldn't a massive new money-printing binge risk significantly higher inflation down the road? Yes — and that's exactly what a central banker would choose if the alternative was deflation.

Deflation — a sustained drop in prices — is not good news 07/24/10 [Last modified: Friday, July 23, 2010 6:39pm]
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