By some measures, deflation in United States is no longer a question of if, but for how long and how deep.
“In a lot of ways the economy is soft and there's absolute deflation in things like computers,” said Barnaby Levin, managing director at HighTower Advisors, which controls $16 billion in client assets.
Of course, any talk of deflation these days conjures up images of Japan, where businesses and consumers have been hoarding cash since the early 1990s while prices of goods and services have steadily declined.
“I think a Japan-like lost decade is a real threat here for all kinds of reasons,” said Mr. Levin. “After the 2008 market meltdown it scared the heck out of all of us and everybody is now pulling back their spending just like our grandparents did during the depression.”
An extreme pullback in consumer spending, coupled with a pattern of reluctant lending by banks, lays the foundation for a deflationary period where prices continue to plummet.
“The probability of a deflation is 25%, so not the baseline scenario but a material-enough risk scenario to be monitored carefully and, where possible, a tail that should be partially hedged,” said Mohamed El-Erian, chief executive and co-chief investment officer of Pacific Investment Management Co.
Mr. El-Erian cited two main factors that make deflation a material risk: “First, policy becomes highly ineffective; and second, the politics of deflation are complex.”
“Japan is a vivid reminder of both these issues,” he said. “So, if you are on a possible road to deflation, as the U.S. is, it is important to get off it as soon as possible, [because] the longer the U.S. stays on this road, the harder it will be to get off it.”
Part of that ineffective government policy has to do with the lack of lending by banks, according to Cleo Chang, portfolio manager with Wilshire Associates Inc., which has $56 billion under advisement.
“There are a lot of issues facing the economy right now, but it's not a [Federal Reserve] issue, it's a Washington issue,” she said.
Ms. Chang, who subadvises the Direxion/Wilshire Dynamic Fund Ticker:(DXDWX), believes the government needs to find a way to get banks to start lending the cash that was made available to them through the stimulus programs.
“The government provided banks with money to lend but it didn't require the banks to lend it out,” she said. “The government was effective in the first part of its plan in getting the money to the banks; now they need to find a way to execute the second half of the plan by getting that money to the small businesses and individuals.”
The deflation riddle gets even more complex when you toss demographics into the equation, according to Mr. Levin of HighTower.
The baby boomer generation is moving toward a period of increased saving; a scenario that could have been predicted regardless of the economic cycle.
“The boomers are now between the ages of 46 and 64, and that means they start to save like the dickens; and that's a good thing, except when everyone is doing it at the same time,” Mr. Levin said.
This savings pattern by boomers further stalls the demand side of the crucial supply-and-demand balance that is needed to boost gross domestic product numbers, and puts more pressure on Washington policymakers to act and react.
“With roughly half the U.S. work force represented by baby boomers, as a nation we're entering into a period of transition to savings mode,” Mr. Levin said. “Government is trying to fill the gaps in spending, but that's just increasing the deficit, and the only way to decrease the deficit is grow [gross domestic product] and/or raise taxes.”
The expanding deficit could be the final shoe to drop in a scenario that would make deflation look like a blessing, he added.
“Right now demand for U.S. debt is driving yield down, but if that demand slows down or steps away, the rates on Treasuries will have to rise [increasing the U.S. government's borrowing costs] and if GDP stays flat that spells
stagflation,” Mr. Levin said. “That is the Fed's absolute deepest fear, because
stagflation is just miserable and it leads to a
recession or depression.”
Mr. El-Erian described
stagflation as a “low probability at this point,” but added that the probability “would materially increase if external holder of Treasuries were to sell.”
