Deflation is working its way back into polite conversation.
After last fall's market declines sparked talk of a possible decline in the overall price level, talk of deflation abated in the first half as financial markets rallied and the economy appeared to bottom. Attention then turned to how and when the Federal Reserve might turn off the monetary spigot to avoid a return to inflation.
But deflation hawks think that the inflation focus is all wrong.
“Deflation is a fact,” said Michael Shinnick, a portfolio manager with Wasatch Advisors Inc.
"NO PRICING POWER'
“The [Consumer Price Index] is negative, the [Producer Price Index] is negative, wages are falling, money velocity has been negative for a year,” and with capacity utilization at about 70%, “firms have no pricing power,” he said.
In August, the CPI for all urban consumers, for all items, fell 1.4% year over year, following a string of declines or very low gains since the end of last year.
The declines in the CPI numbers have “so far basically been driven by declining energy prices,” said economist A. Gary Shilling.
A lot of price weakness in the economy, such as in housing, isn't being picked up yet in the inflation indexes, he said.
“More people are starting to talk about deflation,” said Christopher Hyzy, chief investment officer at U.S. Trust, Bank of America Private Wealth Management, adding that deflationists have been in the minority because the United States hasn't seen serious deflation since the 1930s.
Some deflation theorists hold that the current cycle is a classic debt deflation — the aftermath of overextension of credit, and then its collapse when repayment becomes impossible. The winding down of credit, in turn, leads to contraction of the money supply and causes deflation.
Research on credit bubbles and deflation was done by economist Irving Fisher during the Great Depression and later advanced by Hyman Minsky, a professor of economics at Washington University.
Today, total debt stands at record highs, said Robert Prechter, president of Elliott Wave International, a technical-analysis firm, who has been predicting a deflationary cycle for the past decade.
“The ability to pay interest and principal is still receding,” he wrote in an e-mail.
“When an asset bubble pops, that causes falling wealth, falling spending, job losses and falling incomes,” Mr. Shinnick said. “Then the real whammy comes when people see prices falling and hoard cash, so the value of cash goes up.”
It isn't only deflationists who worry that the United States will get trapped in a Japan-style deflationary period.
“[Fed Chairman] Ben Bernanke and [Treasury Secretary] Timothy Geithner remain vigilant [in fighting deflation] until they see some signs of inflation,” Mr. Hyzy said.
Even the Fed may be underestimating the problem, some say.
“Unofficially, the Fed and the other central banks are targeting a 2% inflation rate, which is too low” to ensure that deflation won't take root, said David Wakefield, senior portfolio manager of the Laudus Mondrian International Fixed Income Fund, which is advised by Mondrian Investment Partners Ltd.
THEORY MEETS DERISION
To be sure, many observers scoff at the idea of a prolonged bout of falling prices. Many predict some return to positive inflation numbers this year and see even more inflationary pressures in the years ahead.
They point to massive deficits and loose money policies that they believe will spark inflation. Lately, there has been a turnaround in some commodities prices and weakness in the dollar, which are also signs that inflation is set to return.
“I love that [deflationists] are pessimistic,” said Jeffrey Mortimer, chief investment officer of
Charles Schwab Investment Management Inc.
“There's a tendency to discount the power and resilience of the U.S. economy,” said Mr. Mortimer, who doesn't buy into the deflationary theme.
Deflation is a risk, he said, “but the bull market rally we've had is signaling that things will get better. March 9 was a textbook bottom, where we saw a junk rally right on schedule” — typical at the end of a bear market.
Yearly inflation figures should turn positive this fall, based on year-over-year comparisons of oil prices, which peaked in the summer of 2008, said John Canally, an investment strategist and economist at LPL Financial.
LPL predicts a return of modest inflation by late 2010.
“Inflation always falls well after the end of recessions,” Mr. Canally said. “Since we're starting in a deflationary period now, the instinct is to say there's more deflation.”
True deflation requires “a complete collapse in consumer demand,” he said, but intervention by the Fed and the government has kept that from happening.
“What people often don't remember about the 1930s is that there was absolutely no safety net, [and] there was nothing done to support the economy for the first few years” after the 1929 crash, Mr. Canally said.
“People who lost their jobs had nothing. People had no buying power,” Mr. Canally said.
“Now there are all sorts of government spending programs” to maintain demand, he said.
In Japan, after the credit bubble popped two decades ago, problem banks were allowed to fester, and the country didn't expand the money supply as it should have, according to LPL research.
But according to deflation hawks, government policies may not be enough to stave off deflation, let alone spark inflation. Just because U.S. policymakers reacted faster than Japan did doesn't mean that their prescriptions will work, they contend.
And deflationists hold that whatever stimulus is being pumped into the economy isn't enough to make up for the collapse of credit and the resulting loss of demand in the private sector.
The destruction of liquidity from deleveraging “is swamping anything the central banks could do,” Mr. Shilling said. “It's like trying to fill a pond with water [but finding out] it's running out faster than it's coming in.”
E-mail Dan Jamieson at [email protected].
