Deflation's the Real Threat

07/16/2009 11:00 am EST


Gary Shilling

Columnist, Forbes

Gary Shilling, editor of INSIGHT, says chronically slow growth will keep inflation from rearing its head, but deflation may be with us for some time.

It appears that the recession will extend into early 2010 By then, enough excess house inventories may be absorbed to moderate the downward pressure on prices [and] most of the global financial woes should be at least stabilized.

Nevertheless, a weak recovery is likely to follow, one so tepid and with such high unemployment, you may not know it has arrived. With recession here and abroad likely to persist into 2010, and a slow recovery thereafter, deflation is likely to dominate for the next year or so, just as it has since last fall.

Four forces point in that direction.

First, the earlier collapse in commodity prices is still working its way through the system. [For example,] despite the recent rebound, crude oil prices are way down from $147 per barrel.

[Second,] wholesalers and retailers were caught flat-footed by the sudden nosedive in consumer spending late last year and continue to unload surplus goods by slashing prices. Third, wages are actually being cut for the first time since the 1930s, so wage costs are moderating rapidly.

A final reason to expect deflation in coming quarters in the US is the shortfall of aggregate demand compared to supply. Evidence of excess capacity abounds.

Furthermore, any liquidity created through central banks is tiny compared to what’s being destroyed by the world’s deleveraging financial sectors.

On balance, we look for slower economic growth here and abroad over the next decade. Real US GDP gains may average around 2% per year, a distinct slowing from the 3.6% in the 1982-2000 exuberant years. And with 2% to 3% deflation, nominal GDP might not gain at all.

Furthermore, the years ahead will probably be unsettling, since economic expansions are likely to be shorter and less robust while recessions are deeper and more frequent.

Few agree with our forecast of chronic deflation. They’ve never seen anything but inflation in their lifetimes, so they think that’s the way God made the world. Few can remember much about the 1930s, the last time deflation reigned.

[But] even with the rapid M2 growth of the last three years, our model predicts low inflation in the next three and likely overestimates what the actual numbers will be. Still, we’ll stay with our forecast of deflation for the remainder of this deep recession, and into the weak recovery that probably will follow. We also look for chronic deflation over the next decade or so as global supply remains ample and demand grows slowly.

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