While Inflation Casts Shadow, Check for Substance: Deflation

It’s an open secret in Washington that Federal Reserve Board Chairman Alan Greenspan believes inflation is below 2% a year and isn’t really rising.

Yet he led the Fed in pushing up short-term interest rates by half a percentage point last week, avowedly to forestall inflation in a still-expanding U.S. economy. The Fed’s action could push up interest charged on bank loans, credit cards and adjustable-rate mortgages--as well as interest paid on bank deposits and money market mutual funds.

The idea is to restrain consumer spending by stick or carrot--by taking away discretionary cash in interest payments or attracting it into savings. The overall intent is to slow the economic expansion so it lasts longer.

But Greenspan’s private instincts are more accurate and revealing. Inflation is not the underlying trend, deflation is--meaning prices and values are more prone to fall than rise. Evidence is abundant. The price of cotton rose sharply last year but the average price of clothing declined 4%, so retailers not only couldn’t raise prices, they had to eat losses. Average wages, salaries and benefits rose 3% last year, the slowest pace since 1981, the Labor Department reported.

In the thriving U.S. industrial economy--which has been serving markets all over the world with record exports--moderate growth rather than boom is becoming the rule.

Keep that deflationary trend in mind. It will help you understand events in the changing economy--why, for example, IBM, General Electric, Walt Disney and other companies are buying in their own shares. Knowing the trend will be critical in considering your own investments.

For instance, if you believed inflation was the trend, it would make sense to take another mortgage loan, add a room to your house or buy a bigger place, secure in the belief that housing prices would rise and you could pay back the loan in depreciating dollars.

Don’t do it! Rising real estate is not a hallmark of this time--in the New York and Los Angeles areas, home prices are still falling. And real interest rates are extraordinarily high.

Consider that Treasury bonds maturing in 10 years or less--the yardstick for many mortgage rates--are paying 7.5% interest and more, while inflation is closer to 1.5%. That’s inflation-adjusted interest of 6%, a very high rate.

The Fed’s latest action raised overnight rates--on which banks and other lenders base their interest charges--to 6%. “Short-term interest normally is 2% above inflation, but now it’s double that,” says economist David Munro of High Frequency Economics, a money market newsletter.

And that raises questions: Why are interest rates so high? And why is the Fed raising them even further?

High rates say the market expects either rising inflation, which would make today’s interest rates seem reasonable, or rising loan demand, which would raise the price of borrowing. But loan demand is not intense and the long-term bond market--as measured by 10- to 30-year Treasury bonds--reacted mildly to last week’s news indicating few fears of inflation.

Just so. Greenspan is trying to keep things loose. “He is following a standard business cycle policy,” explains economist Edward Yardeni of the C.J. Lawrence investment firm. The economy has been expanding at a 4.5% annual rate, factory orders are the highest in 15 years, and labor for some skilled jobs is scarce.

By traditional yardsticks, those are the conditions that overheat the economy and necessitate emergency surgery, such as that performed by then-Fed Chairman Paul Volcker in the early ‘80s when he pushed interest rates close to 20% and caused a recession to break the inflation cycle.

The Fed is being pushed also by international investors’ fears over Mexico, China and other spots, and over the fallout from the derivatives mania, in which many companies--and Orange County--bet on interest rates and now have losses.

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However, the common denominator of uncertainty and derivative losses is that they tend to deflate economies, not inflate them. “The trend may well be deflationary,” says Joan Payden, managing partner of Payden & Rygel, a Los Angeles investment firm specializing in bonds.

In fact, the world economy clearly is slowing to a moderate pace, says Charles Clough, chief investment strategist for Merrill Lynch & Co. One indicator, Clough notes, is that there’s a lot of money around. Banks are reluctant to raise CD rates to attract deposits because they have relatively few opportunities for loans. Debt is not growing rapidly in the economy.

And major companies are buying in their own shares, an admission that they can’t find sufficient investors for their businesses. IBM last week announced a $2.5-billion share purchase, General Electric has announced a $5-billion share purchase over several years, Walt Disney has said that over time it will buy 100 million shares, almost 17% of the outstanding stock.

When companies do that, it’s both a signal and a benefit to investors. Take GE. When the giant company, which has diverse, far-flung operations producing $40 billion in sales and more than $4 billion in profit annually, buys back shares, it is saying that opportunities out there don’t quite add up to all the cash it has available from profits and depreciation on past investments.

So it returns capital to shareholders not by paying dividends, which are taxed twice, to both company and shareholder, but by purchasing stock of those who wish to sell. As such stock is retired, other shareholders increase their percentage ownership, as do company directors and managers--an implicit statement that prospects are good for future earnings.

“IBM’s decision to purchase stock is a vote of confidence by the board of directors,” says computer analyst Bob Djurdjevic of Annex Research in Phoenix.

Stock purchases will be a big trend this decade, says Clough, noting that companies as diverse as Anheuser-Busch, Chemical Bank, Carolina Power & Light, H.J. Heinz, Raytheon and McDonald’s already have stock purchase programs.

Note well also that today’s companies are buying stock with reinvested profits, not borrowed money as companies did in the ‘80s.

The ‘90s are different: Consumers bought sparingly at Christmas but turned out for bargains in January. And count on it: 7.5% interest on Treasury bonds will soon make savings the surprise consumer trend of 1995.

But inflation will not be a trend. Greenspan is both confident and determined on that score. Rather, think deflation.

* More James Flanigan: For a collection of recent columns by James Flanigan, sign on to the TimesLink on-line service and “jump” to keyword “James Flanigan.”