Watch Out for Deflation, Not Inflation
It was easy last week to see inflation ahead for the U.S. economy, but the reality may be just the opposite.
Despite rising oil prices, the real trend in a slow economy is much more likely to be deflation. Other than oil, the price of many things will decline.
That’s not an especially pleasing prospect. Along with lower prices, deflation means falling wages, profits and real estate values.
But whether you’re planning investments or household expenditures, it’s best to face reality. And reality is that rising oil won’t lift other prices, but will eat up what little discretionary purchasing power the American consumer has left.
Figure it out. There are no big wage hikes in the U.S. economy, so consumers’ disposable income isn’t rising--and consumer debt has been up to the limit for some time. So the extra $5 to $10 a week for gasoline and heating fuel will come out of other purchases.
Corporate profits will be under pressure, an obvious downer for stocks, says Charles Clough, chief investment strategist for Merrill Lynch Capital Markets. Deflation also means interest rates will be coming down, which should make today’s high-interest government bonds attractive, although nothing today is a sure bet.
The real story is that the 1990s will not be a rerun of the inflationary 1970s. At that time, when oil prices rose in 1973-74, prices of everything else were already rising. It was an economy stretched tight in the aftermath of the Vietnam War. President Nixon imposed wage and price controls in 1971; the price of bread rose sharply in 1972 when the United States sold grain to the Soviet Union.
Then the 1973 leap in oil prices blew the lid off. An inflationary spiral followed as business passed along fuel increases to customers and employees tried to keep up living standards by demanding higher wages.
Things are different today, even if some businesses don’t recognize it. Many airlines are trying to hike fares 5% to 10% to cover fuel costs. But those fare hikes may not survive in a slow summer for air travel.
Just a month ago American Airlines was forced to withdraw a proposed ticket surcharge for airport costs because competitors wouldn’t go along. It’s hard to raise prices when customers are already staying away.
The deflationary effect will be seen in consumer decisions small and large. McDonald’s reports slackening sales growth in U.S. markets. Movie box office receipts are lagging in what was billed as a “blockbuster” summer.
More significantly, house prices are declining in many parts of the country and commercial property values are falling. “We’ve seen declines in assets, we’re about to see them in profits and wages,” says an investment manager.
“On wages, both our attitudes and our bargaining power are different today,” says Daniel Mitchell, head of the Institute of Industrial Relations at UCLA. In the 1970s we were shocked and offended that foreign oil producers could affect American living standards, and we demanded to be “protected” through rising paychecks.
Today we are no longer shocked, and we understand that inflation does not “protect” living standards. In any case, most workers--union and nonunion alike--don’t have the leverage to demand more pay.
Deflation is not pretty. Unemployment will rise to more than 6%, from today’s 5.3%, in the coming recession, says Mitchell. That’s not as bad as the 1970s in percentage terms, but it still means 7 million to 8 million Americans out of work.
Unfortunately the government won’t be able to alleviate unemployment through public works programs. There is no spare spending capacity; the slow economy and savings and loan bailout have already boosted the federal deficit to historic totals--at least $250 billion in the fiscal year beginning Oct. 1, from $225 billion in the current fiscal year. And with the cost of military action in the Middle East, deficits are likely to keep growing.
That means that the Treasury, which last week sold $32 billion of debt securities at interest rates of 8% (for three-year maturities) to 8.87% (for 30 years), will be selling more debt than usual in the years to come.
There are fears that the Treasury will have to offer even higher rates in the future--which would push down the value of today’s bonds. But experts are divided, with some arguing that the decline of private credit demand in a recession will offset increased government borrowing and thus reduce the need for higher Treasury rates.
It’s a bleak prospect either way, and it contains a bitter lesson. For years economists and politicians have debated whether the federal deficit makes any real difference. Well, we’re about to find out how it limits flexibility in hard times, preventing government spending to repair America’s infrastructure, or a lowering of taxes to revive the economy.
Technically, the deficit also argues against lower interest rates, which will discourage foreign capital from buying Treasury bonds. But you can bet that when more Americans lose their jobs, the Federal Reserve will lower interest rates.
Over time the economy will revive. And maybe we’ll have learned another lesson.
