D-Day: Does Deflation Draw Near?

One month a trend does not make, but today's update on wholesale prices invites the obvious speculation about what may be coming.

As for assessing the here and now, it's clear that the deflationary winds are blowing. Producer prices posted a jaw-dropping 2.8% tumble last month, the Labor Department reports. That's the deepest monthly decline for this series since the Great Depression, although that's just an educated guess since the Labor Department's PPI archive on its web site only has numbers going back to 1947. Since then, last month's drop is by far the biggest.

Monthly declines in the PPI series are hardly unprecedented, even if the magnitude of last month's drop is in a class of its own. But that's not the issue; rather, the economic context of the moment, coupled with a massive price decline in wholesale prices, suggests that an extended bout of deflation may be at hand. Tomorrow brings the October update for consumer prices, and the news is expected to be better, i.e., prices are expected to rise. We'll see.

Why all the anxiety about the potential onset of deflation? To be blunt, avoiding the Big D is always a priority for policymakers. Typically, the inflationary bias does the heavy lifting on that front, leaving governments to worry about other things. But sometimes the pricing landscape turns upside down. Is such a moment at hand? As always, the future's unclear, but it may be time to err on the side of caution about deflation's threat.

Although the prospect of falling prices has obvious appeal for consumers, economically speaking it's a virus that, if allowed to fester, creates any number of problems. The reason is that if deflation takes root, the normal incentive to buy and borrow takes a holiday, which elevates the odds for economic contraction. The fact that the U.S. is already in recession only makes the additional threat of deflation all the more troubling.

If prices are falling and everyone expects more of the same, the temptation increases for delaying purchases to cash in on future discounts. But the sentiment motivates more of the deflationary momentum, which inspires more deferred consumption. At some point, the trend turns into a deflationary spiral that feeds on itself, and at that point there's not much anyone can do to pull the economy out of a dire tailspin.

Borrowing and lending in a deflationary environment also suffer since debt servicing becomes increasingly burdensome. The normal inflationary scenario is borrowing in today's dollars and repaying tomorrow in less-valuable dollars. Under those conditions, there's a natural appeal for assuming loans. The opposite is true with deflation: The expectation of repayment with dearer dollars creates a disincentive for assuming debt. All the more so since purchases implies buying assets that are likely to decline in value, which is no one's idea of a savvy business plan. For obvious reasons, this scenario is a disaster for stimulating economic growth.

History is quite clear on those rare occasions when deflation strikes. The two great 20th century examples of deflationary environments — the Great Depression in the 1930s and Japan's experience for much of the past 18 years — need no explanation for why price declines of any duration must be avoided.

The good news for the moment is that there's still hope. In today's news on producer prices, the primary source of the price decline in October came from collapsing commodities, energy in particular. Core PPI, which strips out food and energy, actually rose last month by a rather robust 0.4%, matching September's gain. Deflation, in other words, hasn't affected all prices. Therein lies the basis for hope that deflation generally can still be avoided.

Nonetheless, today's PPI report sends a strong signal that the risk of deflation has jumped substantially. It's not yet fate, but it could be if policymakers don't act forcefully and in a timely manner. The risk is real, in contrast to the Fed's ill-advised deflation fears in 2001-2003. This time it's the real thing, and the clock may be ticking. Indeed, the recession has only just begun, and so it's not yet clear how deep and enduring demand destruction overall will be.

Tomorrow's consumer price update will offer further guidance on the state of the pricing environment. But given the general economic backdrop of fading demand, which feeds deflation's fires, today's wholesale price report must be taken as a warning sign that the D threat is a real and present danger. If and when deflation has the economy by the throat, the virus becomes far more difficult, if not impossible to contain.

Indeed, the usual monetary levers no longer work in deflation because interest rates can't be negative even though prices can be. And so the limit imposed by what's known as the zero bound in monetary policy may be near. The Fed funds rate is already at 1%, meaning that the opportunities for lowering interest rates are constrained. To be sure, the Fed has alternative means of stimulating demand, although it's unclear how effective such efforts will be, in part because they're so infrequently used. Deflation, in short, is the exception and so there are few real world examples of fighting the beast.

Once again, let's remind that it's not yet clear that deflation is destiny for the U.S. economy, even if the risk has jumped sharply. Much depends on how fiscal and monetary policies unfold in the coming weeks and months. Ditto for the economy. It's possible that the deflationary risk will pass of its own accord, but for the moment that's a risk the country can't afford to take. Better to err on the side of too much stimulus rather than too little.

Yes, there's a risk that the excess stimulus won't be pulled back in once the deflation danger has passed. That too is a potential problem that can't be dismissed. But that's a battle for another day. Now is the time to prepare for an all-out war on preventing deflation.

Comments

[trader1138:]

like a forest fire, deflation cleanses the system to allow new growth. better to let it burn. moral hazard and all that, old boy.

2008 Nov 18 12:22 PM

[Alex Filonov:]

Small correction: Fed's target rate is 1%. Fed's funds rate is under 0.4% now (yesterday's 0.37%, data of NY Fed, available here: www.newyorkfed.org/mar...).

2008 Nov 18 12:25 PM

[cyclingscholar:]

For every borrower hurt by deflation there is a lender helped by it...or have we forgotten that assets must equal liabilities? Deflation is a SYMPTOM of poor economic decisions, not a CAUSE. Restricting free trade and forcing resources into the inefficient public sector (known as a tax increase, for you liberals) made the recessions in 1929 USA and 1980s Japan into the lengthy depressions that they were.

2008 Nov 18 12:32 PM

[RJMoran:]

...A slight easing of our Immigration policy might solve a whole host of problems/ie, housing overstock, deflation, etc. Though it DOES carry with it a few 'wrinkles', it HAS been the way the country has and will continue to grow and prosper. NO?!

2008 Nov 18 12:58 PM

[MarvinMBA:]

Deflation is simply caused by a lack of demand for product and services. Get money into the hands of the public thru Fiscal Policy and Job Growth and the problem will correct. Remember the old supply/demand curves..they still apply today. Another problem that's not talked about is the supply side...from overseas sources that can effect job growth unless the bucks is brought back and jobs are created in the USA. I'm still waiting for the Chinese to come to the USA and start buying low cost assets...get the money circle moving in our direction should be our Leaders efforts going forward...MarvinMBA

2008 Nov 18 12:59 PM

[fatcat:]

Home prices seem to be adjusting back to 1998 levels and stocks are following.Other prices must adjust,like medical expenditures,which have grown even faster than home prices.This is not deflation,per se,just a return to the correct ratio to wages.Wages have dropped only in relation to the above.Once these correct,we should have inflation for awhile,based on the huge infusion of dollars lately...

2008 Nov 18 01:25 PM

[Jolly_Rancher:]

The core rate was actually up. What we're seeing is the effect of wild swings in the energy markets on the PPI. Just a few months ago with oil at 147, many of the same chicken littles were clamoring about inflation going to the moon and the collapse of all - especially the dollar. Now the chicken littles are clamoring about deflation ravaging the economy and the collapse of all civilization. Wild swings in energy prices are part of our lives, an evil that we don't seem to be able to get around. I wish the manic-depressive armchair economists would pipe down.

2008 Nov 18 01:58 PM

[Iconoclast421:]

They've been fighting the inevitable deflation for 5+ years now. In 2005 the threat of deflation increased as oil reached its plateau. The average daily crude oil production for 2006-2008 is down vs the average daily production of 2005. That one fact says it all. They knew it was coming, that's why Alan Greenspend printed trillions of dollars and inflated the money supply. Even with a 500% increase in oil prices, oil production is still at or below 2005 levels. And now production is collapsing. Deflation is absolutely unavoidable. Anyone who has been studying peak oil for the last few years should not be surprised.

Anyone who is surprised by what is happening now should go here:

www.chrismartenson.com...

2008 Nov 18 02:03 PM

[dieuwer:]

I love the herd crowing about deflation! Now we know there ain't any.

2008 Nov 18 02:14 PM

[Chris B:]

Ben Bernanke earned the moniker "Helicopter Ben" in 2003 when he expressed that the Treasury was willing to drop cash from helicopters if that's what it took to dilute the currency enough to destroy deflation, if necessary. Because the government controls the currency supply and can create money out of thin air, I believe him (to increase, or inflate, money supply, the fed creates dollars and uses them to buy back treasury bonds from investors. They sell treasury bonds to reduce money supply).

The various multi-billion dollar bailout and stimulus bills are just another way of executing this threat and injecting dollars into the system. If PPI managed to increase at all at a time when commodities lost half their value within just a couple of months and unemployment increased rapidly, I would say that this boost in money supply has acheived its goal of preventing deflation.

As the recession ends, however, it remains to be seen if the government will overshoot its inflation goal. In order to have a margin of safety, it seems likely that they will produce more than the exact amount of money needed to prevent deflation and will thus spark higher-than-optimal inflation. That is all according to plan, because inflation is so much easier to deal with (just raise rates later).

The downside of managing money supply through government spending rather than treasury auctions is that debts can accumulate rapidly, even in inflation-adjusted terms. Forex markets notice debt in the long term and bid down the currencies of govts that are saddled with debt because of the expectation that they will try to dilute/create the currency to pay it off. This is what happened during the Bush years and it's why I own some TIPS.

2008 Nov 18 02:43 PM

[scootie2008:]

Helicopter Ben sure thinks there is. I think the FED is scared sh*tless about deflation. Bernanke has almost gone through his 2002 D-fence playbook. Unfortunately I don't think the presses run fast enough to stop it. Deflation will be with us for a time - but when all that money finally hits the market, the hyperinflation will not materialize because either A- the whole USD system collapses or B- it will all be okay and we will move forward into broad sunlit uplands....it could happen..

2008 Nov 18 02:46 PM

[Lisaw:]

The govt and the Financiers need to leave it alone. Prices have been too high for "consumers" for 8 years. Rent TRIPLED, incomes did not. So while all you Financiers were raking it in, you were raking the skin off our backs. I pay $2100 a mo just in rent, half my income for a 1500 sq ft for my family. I have excellent credit and my only debt is a student loan. I cannot save because of tripled rent. And now you save your butts after overgambling by requiring future generations of "consumers," my kids, and greatx10grandchildren to pay for it. Well guess what, consumers don't want to consume anymore.
Hell is real, whether you believe in it or not is irrelevant. "Repent," thus says the Lord.

2008 Nov 18 03:31 PM

[museum goer:]

Why do people keep talking about Japan always been in a recession/depression or all this talk about the "lost decade" of the 1990's for Japan. In the 1990's I went to Louvre, and many tourist traps around the world... and in this decade too... Guess what?

the Japanese are there! in $3000 Gucci Croc skin loafters, LV tote bags, prada sweaters, AP watches, with JVC lcd camcorders recording it all. from Paris to Austria to Universal Studios California and Florida... for a nation in a financial downturn I feel like Godzilla in Barney's everytime I go anywhere...

2008 Nov 18 03:32 PM

[dw57:]

we are probably going to have go back to at least 1998 to get things where prices and wages match up in some sustainable fashion. but even that may not work, we may be headed to 1990.

2008 Nov 18 03:52 PM

[Elk Tart:]

Somebody will need to convince me that there is a risk of persistent deflation, when the government is creating hundreds of billions of new money without concomitant economic growth. Surely the only thing that can result from this artificial stimulus is a higher inflation rate, maybe not today or tomorrow, but soon.

2008 Nov 18 04:06 PM

[Socialism c...:]

**Controlled** immigration has always been our standard. Porous borders like we've had with Mexico the last couple decades create HUGE problems. You wanna know why healthcare is so expensive? Go check out the ERs in border states. Wonder why property taxes are out of control? Check out the bill for educating and providing all variety of services to illegals...again, just ask those in border states. Oh, and how about the criminal and drug element that trafficks across the border?

You might just want to check your facts against our current problem set before espousing an opening of the floodgates.


On Nov 18 12:58 PM RJMoran wrote:

> ...A slight easing of our Immigration policy might solve a whole
> host of problems/ie, housing overstock, deflation, etc. Though it
> DOES carry with it a few 'wrinkles', it HAS been the way the country
> has and will continue to grow and prosper. NO?!

2008 Nov 18 06:28 PM

[austrian63:]

I disagree. The deflation in Japan has been very minor. So minor in fact, that due to the strong Yen over the past 10 years the savings rate in Japan has decreased significantly as purchasing power has risen. The Japanese do not fear decreased purchasing power in the future and thus are saving less and spending more actually.

Broad based price declines, which is really what we are talking about, cannot occur in a fiat money system where the government can create money "out of thin air." In the 1930's, the U.S. was still on the Gold Standard, to a degree. But in today's fiat money system the government can and is creating massive amounts of money "out of thin air." In a fiat system, the government can always devalue the currency and ours has already started this process. Be careful you don't plan and prepare for deflation while dollar devaluation accelerates.

As a quick test to disprove the falling price level - most prices are still rising - are your medical bills, your kids' braces, the hotel rates you pay, your kids' college educations, your groceries, your lawyers' fees, your insurance rates, your home repair bills, your car tires, replacement light bulbs, candy bars, etc., etc., etc., cheaper today than they were a month or 1 or two years ago? I bet NOT!!!

Those who wait for braod based falling prices, not sector specific due to popping bubbles, are like Linus waiting for the Great Pumpkin. He will never show.

2008 Nov 18 10:13 PM

[Pent up demand:]

"Deflation is simply caused by a lack of demand for product and services. Get money into the hands of the public thru Fiscal Policy and Job Growth and the problem will correct."

Lack of demand == overinvestment

We have deflation in sectors where easy money created massive over investment. I realize it's fashionable right now to toss out empty phrases like "Job Growth" and "Invest in the Future", but that is meaningless. Government spending is not an investment when it allows someone to keep building houses no one wants to buy, or what have you. These sectors, housing, mortgage origination, car building, etc. have to be brought in line with what consumers are able to buy. Public money will only delay the inevitable for a while, not prevent it.

I wish savers would create an association in their minds that when they hear the words "government stimulus" they visualize a big siphon hose draining money out of their savings.

2008 Nov 20 09:38 AM