Deflation Gets Decoded (James Bell Commentary)

Deflation. It was brought to the forefront with the Federal Open Market Committee’s statement accompanying its May 6 decision to leave the federal funds rate unchanged. According to its statement, the Fed feels the chance of deflation in the next year is greater than the chance of higher inflation.

So what is deflation, anyway? Aren’t lower prices a good thing? Why would the Fed be wary of that? Technically, deflation is a persistent decrease in the general level of prices or a persistent increase in the purchasing power of money due to a reduction in available currency and credit. In a deflationary period, a dollar buys more goods or services in the future than it would today.

In a strong economy, it is natural to expect prices to rise as firms are able to pass price increases along to consumers willing to spend. In this sense, inflation is not a bad thing. In fact, a low, stable inflation rate is part of one of the Fed’s policy objectives, price stability. But in a weak economy, with slow growth, rising unemployment, and faltering consumer confidence, prices tend to moderate as demand slacks off. In order to protect profit margins, companies are forced to cut costs, often leading to layoffs. Combine this vicious cycle with the massive overcapacity in some sectors following the boom of the late 1990s, and the potential exists for a persistent decline in prices: deflation is a symptom of a stagnant economy.

Using year-over-year change in the Consumer Price Index as a measure, there have been fewer than a dozen instances of deflation in the United States since 1914, when the CPI was first tracked. The longest deflationary period was a three year span during the Great Depression, the deepest was in the early 1920s following a massive inflation during World War I. The most recent deflationary period was one year ending in August 1955. For many, the deflation issue represents uncharted waters.

The concept of uninterrupted inflation certainly resonates with most Americans. One contributor to ever-rising costs is the composition of the U.S. economy. As of May 2003, services composed nearly 60 percent of the CPI, with commodities making up the balance. Service prices are described as more “sticky,” meaning price increases are more likely to hold versus commodity prices. In May, service prices were up 3.4 percent year-over-year while commodity prices were up 0.3 percent. The largest and stickiest component of CPI is leading the charge upward.

On the other side of the deflation equation is the money supply. A reduction in the supply of currency or credit can lead to deflation as people look to buy a similar amount of goods and services with fewer available dollars. So far there is no evidence of such contraction: the monetary base and bank credit are growing, and interest rates are near historical lows. Surely no one would argue that the money supply is constrained. The dollar, which has been weak during the past year, is fighting deflation as well, raising the dollar cost of imports while at the same time making imports less competitive to domestic products.

But even with all these positive factors, including 13 interest rate cuts totaling 550 basis points from the Fed since 2000, the economy has not shown signs of strong growth. Unemployment remains relatively high, and businesses have shown little interest in boosting capital expenditures. What economic growth we’ve seen has come from the consumer. But strong, sustainable growth must include corporate spending on both capital and labor. So far, corporations seem unresponsive to economic stimulus. The hurdle seems to be a psychological cycle in which businesses are unwilling to invest until the economy turns, but the economy may not turn until businesses start spending. The Fed stands ready to release more stimulus, as Chairman Alan Greenspan said at a recent conference, “We will lean over backward to make sure we contain deflationary forces.”

Here the Fed may be counteracting market psychology with some psychology of its own. By simply addressing the issue of deflation and its willingness to fight it, the Fed may give businesses the confidence to begin investing, jumpstarting economic growth and removing the specter of deflation. n

James Bell is a chartered financial analyst and vice president and assistant equity portfolio manager at Garner Asset Management Co. LLC, a registered investment advisor in Fayetteville.