Deflation Talk Out in Open as Prices Fall

For years, conventional wisdom has held that inflation is the biggest threat to the U.S. economy. That’s why the Federal Reserve has stood ready to choke off economic growth at the faintest sign of rising prices--even if that meant denting the stock market or stopping the economy in its tracks.

But nowadays, inflation on most fronts is tame. Prices on everything from lumber to crude oil are tumbling to multiyear lows. Consumer prices are rising at a 1.8% annual clip, the lowest in 12 years. Interest rates are tumbling. All but a handful of businesses are terrified of raising prices for fear of losing customers. Wages seem to be the only significant economic variable that is rising much at all.

Indeed, so mild is inflation that a growing number of economists and business leaders are suggesting a scenario thought impossible a few months ago: the chance that prices across the board could actually drop.

This phenomenon, known as deflation, has not happened in a meaningful way in this country since the Great Depression. In the last 40 years, prices have climbed continuously; it was considered a victory if those increases were kept to the low single digits.

But, lately, the Asian financial crisis has combined with a host of longer-term factors to convince some people that prices not only could hold steady for some time, but might even fall.

The extent to which traditional inflation thinking has changed was underscored when comments over the weekend about deflation by Fed Chairman Alan Greenspan sparked a sharp bond-market rally on Monday that drove the yield on the benchmark 30-year Treasury bond to 5.73%, down from 5.82% Friday and the lowest since the government began regular sales of those bonds in 1977.

Greenspan stopped far short of proclaiming deflation a reality in a speech Saturday. But his mere mention of the subject indicated that even the longtime inflation hawk considers lower prices to be a possibility, and it stoked anticipation on Wall Street that the central bank will lower interest rates in coming months.

“This is the first speech by Greenspan when the word ‘deflation’ has appeared so frequently,” said Edward Yardeni, chief economist at Deutsche Morgan Grenfell Inc. in New York. “It certainly suggests that the Fed is starting to realize that deflation is as serious a risk as they believed inflation was.”

A Benign Pricing Environment

The topic of deflation stirs tremendous debate and the majority of economists still believe it is unlikely to occur, especially with wages rising at higher rates. And though falling prices might sound attractive, deflation holds its own set of perils for the economy, such as falling corporate profits that could spark deep layoffs and a recession.

Nevertheless, this much is certain now: The U.S. economy is in the midst of its most benign pricing environment in decades, and that’s having a profoundly positive effect on consumers and many businesses.

As the Christmas season pointed up, retailers are clawing at one another for the right to offer the biggest sales. And anyone shopping for a new home or thinking about refinancing a mortgage rejoices each day bond rates fall, because rates on many types of mortgages and other loans correlate directly to bond yields.

“This is a good time for consumers because they’re enjoying the best of both worlds,” said Cary Leahey, an economist at High Frequency Economics, a Valhalla, N.Y., forecasting firm. “Most people who want a job have one. But they’re only experiencing small price increases and, in some cases, price declines.”

To be sure, not everything is rosy. While businesses are enjoying lower raw materials prices, they’re paying higher wages. And because few companies can raise prices without losing customers, they face the specter of squeezed profits. That could hurt stock prices and, in a worst-case scenario, trigger layoffs if companies scramble to maintain profit margins.

But for the time being, many experts say, moderating prices are likely to drive the economy. They envision a sustained period of what’s known as disinflation. That’s when prices keep rising but by ever-smaller increments each year.

The immediate force behind moderating prices is the Asian financial crisis. The values of most Southeast Asian currencies have slumped dramatically against the dollar. That means exports to the U.S. are suddenly 40% or 50% cheaper.

To try to overcome their fiscal problems, many economists expect Southeast Asian companies to flood the U.S. with a variety of cheaply priced products. That forces U.S. companies to keep their own prices in check to compete.

But as big a role as Asia plays, it’s only one of the several long-term factors that have long been pushing prices down. The biggest has been the opening of global markets in the last decade, including those in China and Eastern Europe, that have given U.S. companies access to cheaper labor as well as new venues in which to sell their products.

A Glut of Capacity in Industries

The rapid development of technology has made companies more efficient and enabled them to cut costs. Strong stock and bond markets have convinced companies, especially those overseas, to borrow heavily to build more factories. But that’s resulted in a glut of manufacturing capacity and a surplus of goods.

There also are industry-specific factors at work: In the retail industry, for example, big retailers have built too many stores in recent years, forcing them to slash prices to move merchandise. In medical care, a backlash against rising costs and other factors have held down price hikes.

Add these up and consumer prices are climbing at a 1.8% annual clip, the lowest level since 1986. And when volatile food and energy prices are factored out, inflation is at its most benign level since Lyndon B. Johnson occupied the White House in the 1960s.

Prices on a number of commodities have been falling. Crude oil fell below $17 a barrel Monday for the first time in two years, and heating oil also dipped because of warm weather across the nation and expectations that Iraq will resume exports. Excess supply pushed down lumber prices 33% last year while copper sank 28%, wheat 15% and cotton 8%.

That’s showing up in a variety of ways for consumers. In the auto industry, for example, analysts say a surge of rebates, low-interest loans and other incentives are cutting the cost of buying a car this year.

Computer prices have experienced deflation for several years. Though prices overall stayed relatively steady, the power of personal computers has regularly improved. And with the advent of so-called network computers that retail for less than $1,000, prices themselves are now declining, experts say.

Even Better News for Home Buyers

For home buyers and mortgage holders, the news has been even better. For example, through Dec. 23, a 30-year fixed-rate mortgage fell to 6.87% from 7.46% six months earlier, according to Mortgage News Co. The National Assn. of Realtors estimates that sales of existing homes hit 4.3 million last year, the best showing since the organization began compiling the figures in 1968. Analysts expect refinancing activity, which already has been hot, to accelerate as rates fall further.

The only losers in this scenario are savers who rely on certificates of deposit and other fixed-income vehicles for current income. They could see the rates they earn slip in coming months.

As attractive as disinflation is for many people, the slide into outright deflation could be very harmful, experts say.

Layoffs resulting from lower corporate profits could feed on themselves as weakening revenues force businesses to fire even more employees.

“When it turns from a low and stable inflation to a general decline in prices, or deflation, then you’ve got a problem,” said William Dudley, chief U.S. economist at Goldman, Sachs & Co.

Consumers might not react well to deflation either. Everybody likes lower prices at the grocery or department store, but they don’t take it well when they’re directly hurt.

“If the value of your house stops going up, most people would perceive that as a negative,” said Erich Heinnemann, a retired Wall Street economist.

Even with Greenspan’s comments, most economists still doubt deflation will take hold. To start, labor costs are estimated to be about two-thirds of average company expenses. They would have to start falling notably for overall costs to slide. Furthermore, economists say that if deflationary pressures build up, the Fed can simply offset them by lowering interest rates.

Wage Pressures Threaten Economy

The most immediate threat to the economic picture might be wage pressures, experts say.

Economists have been mystified that inflation has been coming down when wages have been moving up. The average hourly earnings of rank-and-file production workers--a key indicator of wage pressures--rose by 0.6% in November, after increases of 0.4% in October and 0.3% in September.

“The real problem in 1998 is not inflation,” said Robert Goodman, senior economic advisor at Putnam Investments. Instead, he said, the danger is that corporate earnings will fall.

Improving productivity has offset some of the pressure. Last month, the government reported that worker productivity rose at a 4.1% annual rate in the third quarter, its best showing in five years.

The experience of Pardee Homes, a major Southern California home builder, points up the fine line companies are walking between lower prices for commodities and higher costs for labor.

Prices that the Westwood company pays for lumber dropped about 10% in 1997, said Wesley Lester, head of purchasing and construction. But that’s been counterbalanced by even larger hikes in labor costs.

“You can take all the commodities you want, but with the California economy starting to rebound, especially in real estate, there’s a shortage of quality construction workers,” Lester said. “We’re battling increases in labor that far exceed” any benefits from lower materials costs.

Even so, the company is also gaining from the economic environment. Sales are strong as buyers feel good about their jobs and interest rates. So even with higher wages, Pardee is enjoying its best year since being slammed by California’s early 1990s recession.

“It’s no secret that prices are starting to go up and we’re starting to make some decent profits, whereas our profits were pretty thin or marginal,” Lester said.

* BOND YIELDS PLUNGE: Deflation worries help send yields to 20-year lows. D1