Next Up: Deflation

Posted by Milos Sugovic

Halloween is over, but the scare isn’t. This time, deflation is the monster in the room that has economists and businesses talking. There’s considerable debate whether the US and its industrial partners could see a sustained decline in consumer prices. Some predict a doomsday scenario, also known as stag-deflation, where deflation is associated with stagnation, a prolonged period of slow or negative economic growth. Others think it’s premature to be worrying because inflation is embedded in the US and European economy and the policy response to the financial crisis. But no matter what side you take on this issue, deflation is a risk and businesses will adapt accordingly.

Deflation is defined as a sustained fall in general prices. So if goods and services are cheaper, isn’t that good? Far from it. The economy can easily get trapped in a deflationary spiral, a vicious circle where a decrease in prices leads to lower production, which in turn lowers wages and demand, which leads to further decreases in prices. In effect, the problem becomes its own cause. That’s why central banks are mandated to maintain a healthy level of inflation, not deflation.

So what might be causing it? Take your pick: the goods, labor, commodity, and financial markets are all sending the same signals.  

Let’s start with the goods market: Aggregate supply already exceeds aggregate demand, which keeps falling in many sectors. It’s due to the US economic downturn, and it’s putting downward pressure on prices. There’s excess capacity for the production of manufactured goods as investments in Asia, particularly China, created a surplus that will remain unsold as global demand falls.

The labor market is no different. The unemployment rate is up sharply, which means wage increases are unlikely. Add to that a hiring freeze, and the labor market is seeing a piling up of excess labor that’ll keep driving down wages.

Commodity prices peaked in July. Today, they’re down by about 30 percent and are likely to fall much more in the coming months. Just look at oil prices, which were sliced by over 50 percent. So we’re seeing a collapse of both headline and core inflation. That’s why core inflation, which includes food and energy costs, is the key measure to watch.

Financial market investors are already ahead of the game. Gold prices -- a typical hedge against inflation -- are sharply falling. More importantly, yields on Treasury inflation-protected securities are higher than on conventional Treasuries. The difference between the two, a proxy for expectations on Wall Street, has been reduced which indicates deflationary expectations.

So all indicators point in the same direction: there’s deflationary pressure and businesses will be the first to feel it. Deflation is bad news for profits, and that’s why businesses will turn to some combination of the following remedies:

Adapt – Deflation doesn’t cut across all sectors, and that creates incentives for substitution of production factors. If gas is expensive, invest in technology or alternative fuels.

Shorten cycles – To take advantage of dropping prices businesses will look to reduce inventory levels and will order smaller amounts in shorter cycles.

Create a niche – Commodity prices are volatile, so look to de-commodify your goods and services in order to maintain markup.

Productivity – It’s easier said than done, but invest in factors of production (such as technology) that are facing a drop in prices. You’ll cut costs and boost productivity.

Review contracts – Consider the impact of long-term contracts, which lock you into high prices, and look to renegotiate.

Cut the fat – There are a lot of “nice to have” goods and services. But what or who is having an undesirable impact on the bottom line?

At the end of the day, business will have to make some tough decisions, ranging from cutting wages or offshoring operations to contributing to the unemployment pool. The question many forget during tough times is: how will the public react, in what way will it impact our business, and can we do anything about it? Reputation is inevitably at risk, and there’s no need to let it slip.

The last thing you need after a drop in profit is a reputation that follows suit.

Comments

[Curt]

Yes, we are in a deflationary period, but the risk is growing that the world is tired of borrowing America money. If the global economic conditions continue to worsen, many nations may abandon the dollar - which would cause the dollar value to sink, resulting in massive inflation.

The current deflationary period will continue until the assets (cars, houses) are liquidated, perhaps another year. But, after that, the highly inflationary monetary policies of our government are likely to overwhelm the market with inflation.

Therefore, in time inflation will overtake deflation. The combination will be desasterous. The deflationary period will cause a lot of job losses and losses of assets, then the inflationary period will spike interest rates so that even if you did have any money left it will cost you more to get a loan and have less value.

[Milos Sugovic]

Curt, thanks for the post. I think you bring up a few important distinctions here, that is, short-term versus long-term effects of the recession on inflation, and the pressures that come from within and from abroad. In the short-run deflation seems unavoidable as aggregate demand dropped, credit dried up, unemployment is high, inventory is piling up domestically and abroad, and the list goes on and on. What’ll happen in the long-run is less clear as dollar flight is likely. But it’s debatable if inflationary pressure coming from monetary policy, a depreciation of the dollar, and government spending will counteract the pressure coming from the hurting goods, labor, and capital markets. What’s most alarming is that a short-term deflation may be the US’s entry into a liquidity trap a la Japan, which I’ve discussed on http://peppercomblog.typepad.com/my_weblog/2008/05/will-the-us-flo.html and I notice you have too. And as you mention in your post http://www.pennyjobs.com/pp/public/Articles.aspx?aid=225, if the US stays in an L-shaped recession, we could see a Japan-like effect. If that happens, the short-term deflation might not be so short after all.