Deflation May Be the Real Enemy
04/08/2010 2:00 pm EST
Listen to financial commentators and investment gurus these days, and you’ll find nearly unanimous agreement that inflation is just around the corner.
To combat the financial crisis, central banks flooded the system with liquidity. Once the economy recovers, the argument goes, all that money will flood the system, boosting inflation.
Some, like Peter Schiff and Dr. Marc Faber, have even made the outlandish claim that we’re on the verge of hyperinflation, just like in Weimar Germany or Zimbabwe.
Yet the greater danger may be the one we’ve been fighting all along: deflation, an outright decline in prices. Even if we do have a decent recovery, chronic unemployment and underemployment, vast overcapacity, and the inability of banks to lend freely may all keep price increases minimal, if they don’t actually fall.
Deflation has been a fact of life in Japan, where businesses are locked in a desperate struggle to maintain pricing power and profitability. It’s cropping up in some parts of Europe, too.
And it’s increasingly on the radar screen of the Federal Reserve Board, where one prominent Bank president has reassessed his own hawkishness on inflation. Other Fed officials are quietly ruling out any increases in short-term interest rates for now.
With interest rates at zero, there’s little the Fed can do now to stop a new deflationary spiral. And with the US government already deep in debt, the Obama administration and Congress have no wiggle room to add more massive government spending.
One outside possibility: We could have price disinflation or deflation combined with rising long-term interest rates as wary investors demand a higher return on Treasury securities because of the US’s precarious financial position.
While unlikely, that scenario would not be unprecedented, and it would be bad news for investors who’ve loaded up on gold and commodities, anticipating inflation’s return.
Because despite all the Fed’s actions, deflation remains a danger. In February, US consumer prices rose by only 0.1%, and they increased only 1.6% (2.3% including food and energy) over the past year, the smallest increase in six years.
That may be why inflation hawk Richard Fisher, president of the Federal Reserve Bank of Dallas, who urged the Fed to hike rates in 2008, made this astonishing comment in an interview with The Wall Street Journal this week:
“Because of the enormous slack in the system, and as you know I tend to be very vigilant about inflation, we’re just not seeing price pressures right now. If anything, the tail risks are on the deflationary side.”
He joins the doves—such as San Francisco Fed president Janet Yellen and New York Fed president William Dudley—in the battle for the soul of the Fed. Their faction’s growing influence makes increases in the federal funds rate highly unlikely any time soon.
Their biggest worry—and the reason deflation is a danger—gets back to one thing: overcapacity. Factories still have too much idle capacity in face of consumers’ reduced demands for automobiles, refrigerators, what have you. There are too many unsold homes, too many ghost-town malls, too much see-through office space in America now.
And with unemployment at 9.7%, total “underemployment” at 17%, and wages and the average work week stagnant, there’s no catalyst in sight to either boost wages or drive demand higher.
As Kenneth Rogoff, a professor at Harvard University, who with Carmen Reinhart wrote the definitive book on financial crises, This Time Is Different, told the Journal:
"There is still a lot of unemployment and excess capacity all over the place. In the short term, deflation is much more the risk."|pagebreak|
Also critical: Business lending has yet to come back, more than a year and a half after Lehman Brothers’ collapse; in fact, it’s still shrinking. While big corporations have filled up their tanks with cash in the bond market, owners of smaller companies are going hat in hand to their local bankers, and are having the doors slammed in their faces.
In 2009 bank lending suffered its sharpest decline since 1942—the year after the Japanese attacked Pearl Harbor. Banks large and small are burdened with bad loans of all kinds on their books—they wrote down more than $50 billion worth in last year’s fourth quarter, and may have to take losses in the hundreds of billions of dollars in coming years, according to Deutsche Bank. Meanwhile, skittish regulators are demanding they boost capital.
All in all, an estimated $700 billion of credit has been pulled from the system, nearly matching the total amount of last year’s economic stimulus package.
The upshot: Even the most creditworthy borrowers can’t get loans. So, don’t expect small businesses, which create nearly half the jobs in the US, to do much hiring any time soon.
Again, persistently high unemployment means no wage pressures, continued slack demand, and persistent overcapacity. Add them up and you get disinflation or outright deflation.
We’ve been here before—and Japan is there now. Japan is mired in deflation amid an aging population, a huge debt load, and weak export markets. Its consumer price index fell for the twelfth consecutive month in February, and deflation appears to be picking up steam.
Though we have a flexible labor market, a much more competitive economy, and an individualistic, entrepreneurial culture, the risk is there. A. Gary Shilling, publisher of INSIGHT and a long-time believer that deflation is a big threat, says simply: “We’re moving more towards the Japanese model.”
And maybe the European model, too: Ireland, whose banking, budgetary, and housing crisis resembles that of the US, has seen a 2.6% decline in consumer prices. Spain, whose unemployment rate approaches 20%, may be next in line.
And what about us? Deflation or even low inflation would make our fiscal crisis even worse by cutting into companies’ profits—and tax revenues, leaving bigger holes in federal, state, and local budgets. And yes, rates can increase or remain high amid deflation.
From 1929 to 1933, during the deflationary Great Depression, yields on high-quality corporate bonds held up, says Steve H. Hanke, an economics professor at Johns Hopkins University. “So, there have been deflationary periods in which nominal yields actually rose, and of course, real yields soared,” he writes in an e-mailed response to my questions.
The combination of deflation and high rates could be devastating. Stocks do poorly in that environment, and most bonds would be hurt by rising interest rates, although Hanke says “very high-quality bonds should do well.” Cash might be OK, if money market funds raised rates to stay competitive. Gold and commodities, however, would probably get creamed.
The inflation bugs would be quick to point out that oil and other commodities like copper have been rallying of late. But this looks like a classic speculative binge during a seasonally strong time for commodities. And the economy appears to be bouncing back nicely, yet overcapacity and deflation could undermine the nascent recovery.
That may be the real danger the market and the rest of us are facing, whether or not we’re paying attention.
Howard R. Gold is executive editor of MoneyShow.com. The views expressed here are his own.