Which ‘flation to fear more?
When the global economy began its dive eight months ago, one of Wall Street’s biggest fears was that a deflationary spiral would kick in -- falling prices for goods and services leading to falling wages, in a vicious circle that governments and their central banks would be unable to stop.
Yet so far, the worst-case deflation scenario has failed to materialize. In fact, depending on how you spend your money, you may be suffering much more from higher prices in this deep recession than you’re benefiting from lower prices.
On its face, the government’s main inflation gauge, the consumer price index, mostly has been pointing lower since October. The CPI was flat in April compared with March and fell at a 3.9% annualized rate, seasonally adjusted, over the previous six months, the government reported Friday.
That sounds like deflation. But the decline was largely the result of a plunge in energy costs. Gasoline prices fell at a 63% annualized rate in the six-month period, for example, even though they have rebounded in recent months.
Prices of many other goods and services have continued to rise despite the recession. Within the CPI, medical expenses rose at a 3.8% annualized rate over the last six months. Clothing costs were up at a 1.2% rate; personal-care products such as toiletries jumped at a 5% rate.
Nobody likes to pay higher prices, but the lack of deflation in many CPI categories counts as good news if you’re worried about a worse economic calamity. Price cuts in moderation are wonderful for consumers. But actual deflation -- broad-based and persistent price markdowns -- would imply that the economy was falling into a black hole.
Some analysts, however, say it’s just a matter of time before deflation takes hold in a world where the jobless rate is soaring, massive wealth has been lost to the stock and housing markets’ crashes, and a huge swath of manufacturing capacity is sitting idle.
“I think people in general are underestimating the deflationary forces that are out there,” said Brian Bethune, an economist at IHS Global Insight in Lexington, Mass.
If he’s right, investors could be put through the wringer again. Forced discounting of goods and services by desperate companies could cause more severe damage to their earnings, which could be disastrous for the stock market.
In that environment many investors probably would run back to the safety of government bonds, as they did last fall during the credit meltdown. If inflation is negative for an extended period, the current 3.1% annualized yield on a 10-year Treasury note could be a spectacular return.
For the moment, it’s clear that financial markets overall don’t buy the deflation scenario. The stock market has rallied sharply since early March and Treasury bond yields have been rising for most of this year. Prices of many commodities, including oil, also have jumped in the last two months.
The markets have been taking their cue from the massive amounts of money that governments and central banks worldwide have been pumping into the financial system.
“The aggressiveness of this response is unprecedented,” said Paul Kasriel, chief economist at Northern Trust Co. in Chicago. And he believes it will do the trick, underpinning an economic turnaround that will keep deflation at bay. “I don’t think we’re at risk for a significant deflation,” he said.
Indeed, in recent months, the opposite concern has come to the fore: Flooding the financial system and economy with money, many economists believe, sows the seeds of a future jump in inflation.
Central bankers wouldn’t mind that so much, because they believe that subduing inflation would be a far easier task than halting a deflation spiral. As Japan’s deflation experience showed in the late 1990s, a major risk is that falling prices breed more of the same as consumers figure it’s smarter to wait to buy.
“There’s more of an incentive to postpone spending if prices are going down,” Bethune notes.
In that context, it’s easy for Federal Reserve policymakers to look at the recent trend in the CPI to justify keeping the money spigot wide open for the time being.
The CPI was down 0.7% in April from a year earlier. Before this year, the last time the index went negative year-over-year was in 1955.
And although the steep drop in energy prices has been the driving force behind the CPI’s decline, food costs in the index have fallen overall for the last three months, and the index’s clothing and housing components have been negative the last two months.
Still, some analysts say it’s surprising that price declines haven’t been broader and deeper, considering how the global economy fell of a cliff beginning in September.
Joe Carson, economist at money manager AllianceBernstein in New York, says many companies appear to have forestalled the need for severe price discounting by quickly slashing production as the recession deepened.
“Technology has given them a faster feed on sales trends,” he said.
Also, services -- including housing costs -- account for 60% of the CPI. Prices for many services historically have been notoriously “sticky.” And the way the government calculates housing costs, including rents, has long frustrated economists who say it doesn’t truly measure what is happening in the housing market.
That has been a glaring deficiency in the CPI amid the housing crash, Bethune said.
Despite the props under the CPI, Lacy Hunt, economist at Hoisington Investment Management in Austin, Texas, asserts that deflation hasn’t been defeated -- just delayed.
“The greatest deflation threat is ahead of us, not behind us,” Hunt said.
Inflation is a lagging indicator; since 1950, inflation has reached its lowest points on average 29 months after recessions, Hunt said. And this time around, “We’ve got huge amounts of excess capacity in labor markets and everywhere else,” he said. Coupled with consumers’ need to save money to rebuild their finances, that’s a recipe for deflation despite the tidal wave of money that central banks are making available, he said.
For investors, the lack of clarity on the inflation issue suggests that a middle ground is still the best place to be, wimpy as that will sound: Keep some bet (probably stocks) that governments can beat deflation, but have a hedge (like Treasury bonds or cash) in case they’re too late.
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