Deflation? Don't Hope For Discounts

Don't Hope For Discounts
If Deflation Sticks Around, History Is Clear: It's Bad News For All But A Few

By Laura Mandaro, Marketwatch | 18 February 2009

The Spiral: Playing the deflation threat

SAN FRANCISCO (MarketWatch)— Bargain shoppers, beware. The last time a major economy experienced repeat price cuts across a broad range of consumer goods, the stock market lost 80% of its value and unemployment hit its highest level since World War II. That was the outcome of Japan's bruising bout with deflation, which crept into the world's second-largest economy in the mid-1990s and didn't let up until 2006.

• Special Report: The Spiral
• The Fed: Deflation a key risk, says St. Louis Fed's Bullard
• Bad news for almost everyone
• Will it spell disaster for stocks?
• Bondholders like their chances
• Japan experience as cautionary tale
• It's costing cows their lives
• 'Deflation party' is unlikely to endure
• The hyperinflation view

Deflation?

As unappetizing as it sounds, a U.S. version of Japan's so-called 'lost decade' could be in the works. A two-year slump in house prices has spread into a broad recession, sapping demand and driving down prices of manufactured items like cars and clothes as well as commodities like gasoline and milk. The consumer price index, the most widely watched barometer of inflation, will likely go negative this year.

Deflation isn't here yet, says Sherry Cooper, chief economist for BMO Capital Markets, "but it's the closest we've come since the Great Depression. Housing prices are falling, commodity prices are falling, so are lots of goods and services— that sounds scary to me," she said. And some of the projections are enough to keep folks up at night.

U.S. consumer inflation is expected to fall 2% this year, according to RGE Monitor, the economic research firm lead by New York University's Nouriel Roubini. The group also predicts deflation could persist until 2010 while the country flirts with "a near depression," says Christian Menegatti, an RGE analyst.

David Rosenberg, the notoriously bearish North American economist at Bank of America Securities-Merrill Lynch, sees deflation as the "primary risk" to investments in the near future. He expects the CPI to post year-over-year drops every quarter this year. "It is truly difficult to believe inflation is going to be revived in the intermediate term," as Rosenberg put it in a report last month.

Alternate Case: Prices Rise

Some forecasters are more optimistic, predicting that Washington's pending economic stimulus package and the trillions of dollars the Federal Reserve and Treasury Department are injecting into the banking system will lower borrowing costs, stimulate purchases and keep prices rising. "I think we can probably avoid it," said Nariman Behravesh, chief economist for IHS Global Insight. That's "mostly because of the very aggressive monetary policy response and what we're likely to see in terms of fiscal policy".

Indeed, some market indicators are signaling more expectations of inflation rather than deflation— or at least the economic growth that usually accompanies rising prices. Gold, a hard asset that can hold its (relative) value even as prices inflate, has risen more than $60 from the start of the year, or about 7%, to about $948. Copper, the metal analysts term "Dr. Copper" for its ability to forecast economic growth, has also rallied about 9% this year after tumbling 54% last year. See story on copper.

Yields on Treasury bonds have moved sharply higher since the start of the year, though some analysts say that's largely a result of the massive amount of new Treasury debt flooding the market. See feature on deflation and the bond market.

Regardless of these recent market moves, the Federal Reserve is pulling out all the stops to avoid a replay of Japan's run with deflation or a scenario closer to home— the slump in prices that accompanied the Great Depression. The worry about deflation comes from the top. It was Fed Chairman Ben Bernanke's November 2002 speech on preventing Japanese-style deflation that earned him the nickname "Helicopter Ben" for his reference to policy-makers' willingness to air-drop money onto the economy to keep consumer prices rising. Today's Fed and Treasury intend to shower the financial system with at least $2.6 trillion via bond purchases and guarantees, capital injections to banks and cheap loans to financial intermediaries.

Pensioners Win, Borrowers Lose

Central bankers know that very few benefit from a protracted period of deflation. In Japan's 1990s, retirees with fixed incomes were happy as goods prices fell. But Japanese workers were hurt by lost income as the unemployment rate breached 5%. That's low by U.S. standards but it marked the highest levels since Japan started keeping detailed statistics in the early 1950s. See memoir of falling prices in Japan.

"What was good for the retirees wasn't necessarily good for anyone else," said Barry Eichengreen, professor of economics at the University of California, Berkeley. Sustained falling prices hurt anyone who owes money, such as a homeowner with a fixed mortgage. Grocery and gasoline bills fall when deflation is rampant. But homeowners and other debtors have a harder time making fixed monthly interest payments if struggling employers clip bonuses and lower wages.

The same goes for companies that have borrowed for capital purposes and face a cash crunch as sales founder. "It's your nightmare scenario," said Myles Zyblock, chief institutional strategist for RBC Capital Markets. "You could have fresh waves of bad debt." Banks stand to get cheaper funds, as savers sock away more money. The U.S. savings rate has climbed to 3.6%, surging from near zero during the last two years.

But a richer trove of deposits probably would not be enough to offset other pains that accompany deflation— such as higher defaults. Just as in today's housing market, falling prices make it hard for the borrower to sell assets to pay off a loan. And the lender is left holding collateral that's worth a lot less.

"Funding may benefit the banks while people with capital who are risk-averse may want to move into the banking system," said Jeff Davis, director of research at brokerage Howe Barnes Hoefer & Arnett who is also a bank analyst. But if asset values keep falling, as they have in the housing market, "by definition, bank capital comes under pressure." That pressure has already crushed the stock prices of giant lenders like Citigroup (C) and Bank of America Corp. (BAC), ushering in a new era of government ownership in the banking sector. See 'Stock slaughter' feature.

Gas And Milk, Cheaper By The Gallon

Economists and policy-makers have been watching U.S. consumer spending contract, prices flatten and savings climb. So far, official deflation— regarded by academics as a broad decline in prices over at least a year— hasn't materialized. It's come close, however. The U.S. consumer price index rose 0.1% in December from the prior year, the smallest increase in 54 years. Month to month, consumer prices have fallen for four of the past five months.

Most notably, the price of gasoline and milk both have dropped more than 40% in the past year, and used car prices have slid 8%. Clothing is down 1%. Wages and benefits are still growing, but at a slower pace, as companies from Caterpillar (CAT) to Boeing Co. (BA) to Starbucks (SBUX) to AT&T (T) cut jobs. The employment cost index rose at its slowest rate in at least 26 years last year.

Deflation is likely to occur this year if oil prices stick near $40— or less than half their levels a year ago. Economists surveyed by The Blue Chip Economic Indicators anticipate consumer prices will drop 0.8% this year.

'Malign Deflation'

U.S. consumers are used to seeing the price of manufactured items like laptops and T-shirts fall year after year while commodities prices make big swings. Earlier this decade, oil prices traded under $12 a barrel. Such deflation isn't bad news because prices are falling as companies find more efficient ways to make products. Wealth is created in that process as people's buying power and standard of living rise.

But this time around, prices are mostly being driven lower by a damaging drop in demand, which raises alarm bells. The International Monetary Fund sees many of the same pressures around the globe. It estimates the risk of "malign deflation" is much greater to the world economy than during the 2002 to 2003 deflation scare.

"If inflation is falling by 2% a year, people won't buy a car or TV, because they know anything they'll consider buying will be cheaper next year," said UC Berkeley's Eichengreen. "If no one's buying, no one's producing and no one's hiring— that's the problem we are trying anxiously to avoid."

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