In the great debate over whether inflation or deflation is the bigger risk to the U.S. economy, the deflationists have seized the upper hand. Only months ago, the conventional wisdom was that massive fiscal and monetary stimulus would inevitably lead to inflation — and buying long-term bonds was a fool’s game. But with growth slowing and the Fed determined to hold interest rates low indefinitely, the opinion meter has flipped. Now the boogey monster du jour is deflation.
No one is talking about a return to the deep deflation experienced during the Great Depression. In 1932, U.S. consumer prices fell 10 percent, and between 1929 and 1933 they dove an extraordinary 27 percent. Rather, fears now seem to be centered on a repeat of Japan’s lost decade, where consumer prices have been falling for more than 15 years, though never more than 2 percent a year. Still, a deflationary psychology has grabbed hold there, turning Japan into a zombie economy that no matter of fiscal or monetary stimulus seems able to snap out of its doldrums.
While central bankers have honed their skills at fighting inflation by raising interest rates — think Paul Volcker in the mid-1980s — Japan has still not been able to successfully combat deflation. And it took World War II and its massive demand for workers and industrial production to end the Great Depression. No wonder economists surveyed by The Wall Street Journal said deflation was a bigger threat to growth than inflation by a margin of two to one.
The fear is that a deflationary psychology takes hold in America at a time when the economy is faltering, and consumers, who have been diligently trimming spending and bolstering saving, become extreme thrift-aholics, which in turn saps profits and prevents businesses from investing and hiring. And so, the natural post-recession healing process of rising profits leading to rising private investment and hiring gets stopped in its tracks.
Indeed, the Fed’s recent decision to extend its quantitative easing program seemed to be motivated in part by warnings from James Bullard, president of the St. Louis Fed, and others of mounting deflationary risks. But not everyone, even at the Fed, agrees. Charles Plosser, president of the Philadelphia Fed, has said fears of deflation are “probably overblown.” And we are certainly not there yet. "Reasonable people can argue that there's a risk of deflation,” said Richard Fisher, president of the Dallas Fed, “but we haven't seen it in the numbers yet."
Inflation vs. Deflation: Or Both at Once?
For all the ink that’s been spilled about deflation of late, it’s important to remember that prices are still rising, albeit slowly. The Consumer Price Index (CPI) rose 0.3 percent in July — the biggest monthly increase in a year — and 1.2 percent over the last 12 months. And if you look beneath the headline numbers, you see a split-screen phenomenon with domestically driven deflation and imported inflation.
Domestically, we have a weak economy and falling prices for residential real estate and many services. Prices for communications services fell in July, while cost increases for health care, education and eating out have slowed. Food prices = also dropped slightly in July, due to a sharp drop in the price of fruits and vegetables, which offset rising prices for other food products.
Signs of slowing economic growth have recently sent stocks falling and consumers back into their foxholes.
On the other hand, fast economic growth has driven up prices and asset values in China, India, Brazil and other emerging markets. And they have been exporting that inflation to us in the form of rising prices for imported goods and commodities. Over the last 12 months, consumer costs for energy rose 5.2 percent, accounting for over two-thirds of the increase in prices over the last year. Prices for used cars and trucks are up a whopping 17 percent in the last 12 months. Also still rising, though less so than in the past: health care, education costs and airline fares.
Another sign that deflation has not taken hold yet: The just-released Core Producer Price Index (PPI) on finished goods (except food and energy) bucked its three-month trend of declining prices and rose 0.3 percent in July, above the 0.1 percent estimate. The increase, which was driven by higher prices for food, autos, pick-up trucks and pharmaceuticals, is the highest month-over-month increase in the core PPI since January. Year over year, core PPI rose 1.5 percent — still moderate, but the highest seen since last September.
The Inflection Point
The American consumer is at an inflection point. The Great Recession hit Americans’ net worth — and confidence — in the solar plexus. Recent months have shown glimmers of hope: a slight pickup in private sector hiring, signs that the housing market has stabilized, and until recently a stock market rally and cautious comeback in consumer spending. But signs of slowing economic growth have recently sent stocks falling and consumers back into their foxholes. After rising at a 4 percent rate during the last half of 2009 and the first quarter of this year, consumer spending growth slowed to about 1.7 percent in the second quarter. Still, consumer confidence inched up in August, as did retail sales, though that was largely due to auto and gasoline sales. And retailers are expecting a tough back-to-school season.
Unless there are some clearer signs of improvement in employment, income generation and stocks — which are likely to take some time — American consumers may just stay hunkered down. Then the beginning of a virtuous cycle of increased consumer spending and business investment and hiring could stall or, worse yet, turn into a vicious deflationary cycle as the fear factor kicks in.
What could turn things around?
I keep coming back to the notion that we’re in a high-stakes confidence game. The Fed took an important step last week. By promising to keep the fed funds rate low for an extended period and purchase long-term Treasurys, it sent a message to investors that long and short rates would stay low for a while. That, in turn, encourages banks to lend and individuals and businesses to borrow. Also, we are seeing a slight loosening of lending standards, according to Fed surveys of loan officers.
But the other big uncertainty out there is tax rates. If President Obama and Congress could agree on how to handle the Bush tax cuts, which expire next year, investors would get a much-needed boost in confidence. As one market strategist put it: “I don’t care what they do, as long as they do something.”
The markets want clarity. If Washington delivers, and the equity markets rebound, that could be a mood-changer for consumers and business, which in turn could trigger a virtuous cycle for the economy and incumbents as well. Hint to Washington: We’re all in this together. After all, an upbeat voter is an incumbent’s best friend.