The big economic news last week was the dramatic drop in the consumer and producer price indicies.  On November 18, 2008, the Bureau of Labor Statistics (BLS) announced:

The Producer Price Index [PPI] for Finished Goods fell 2.8 percent in October, seasonally adjusted, the Bureau of Labor Statistics of the U.S. Department of Labor reported today. This decrease followed a 0.4-percent decline in September and a 0.9-percent fall in August. At the earlier stages of processing, prices received by manufacturers of intermediate goods moved down 3.9 percent in October after declining 1.2 percent in September, and the crude goods index dropped 18.6 percent subsequent to a 7.9-percent decrease in the previous month.

The next day, the BLS issued the Consumer Price Index (CPI) for October 2008, stating:

The Consumer Price Index for All Urban Consumers (CPI-U) decreased
1.0 percent in October, before seasonal adjustment, the Bureau of Labor
Statistics of the U.S. Department of Labor reported today.  The October
level of 216.573 (1982-84=100) was 3.7 percent higher than in October
2007.

The big drop of 1 percent in one month reflected the cascading decline in commodities prices that began in July 2008 and has continued since as the world economy sinks further into recession.  This drop has sparked fears of deflation.  However, while the drop in consumer prices, most notably due to the drop in energy prices, may indicate a future continuation of a drop in prices for all goods, for now, it simply denotes disinflation, or a falling inflation rate.  Compared to October 2007, the CPI was up 3.7 percent.

In an article posted at RGEMonitor.com, Michael F. Bryan, vice president and senior economist in the Research Department of the Federal Reserve Bank of Atlanta, asserts that the ”drop-off in consumer prices seems to have been prompted by a number of factors, including some pass-through from sharply lower commodity prices, a stronger dollar (which makes import prices cheaper), and very soft consumer spending.”  Bryan concludes, “The overall and the core CPI posted declines for the month and clearly there is significant, rather broadly based downward pressure on retail prices. But as I cut the data, it looks to me that the October CPI data is pointing to an inflation rate somewhere in the 0.5 percent to 1.5 percent range.”  So, he sees a lower inflation rate (disinflation), but not deflation, but one should note that this is his conclusion based on the most recent report.  Bryan correctly concludes that one can only take so much away from one report.  We need several data points, or several negative PPI and CPI reports, to reach a reasoned conclusion that deflation is either on its way or has arrived.

Stag-deflation

Stag-deflation is an economic condition whereby economic growth is either at a standstill or showing very anemic growth while the economy suffers from a wage-price spiral, as consumer and business spending freezes and the monetary supply contracts.  There is a possibility that we could be heading for such a disaster, even with the federal government and central bank’s efforts.  Please note, as I have discussed above, there is no hard evidence of deflation yet, so this is only a possibility based on what appears to be the beginning of a trend.  I raise this now, so you may begin to prepare for it.

First, we need to take a look at some economic forecasts.  The International Monetary Fund recently posited

prospects for global growth have deteriorated over the past month.  World growth is projected to slow from 5% in 2007 to 3¾% in 2008 and to just over 2% in 2009, with the downturn led by advanced economies.  U.S. to contract (-0.7%) in 2009, after growth of 1.4% this year; Growth to be “particularly weak” in the G-7 countries — the U.S., Japan, Germany, France, the U.K., Canada and Italy.  U.K. to contract (-1.3%) next year; Italy’s economy will contract in 2009 (-0.6%); Germany is expected contract in 2009 (-0.8%); France’s economy will contract in 2009 (-0.5%); ; Canada to grow 0.3% in 2009.  In emerging economies, growth is projected to slow appreciably but still reach 5% in 2009. However, these forecasts are based on current policies. Global action to support financial markets and provide further fiscal stimulus and monetary easing can help limit the decline in world growth. 2009 projections Brazil (3%), India (6.3%), Russia (3.5%), China(8.5%) [SOURCE: RGEMonitor.com].

There is no question that growth is stagnating, but what about deflation?  Professor Nouriel Roubini believes that stag-deflation is well under way.  He points to the rapid decline in commodities and housing prices and the rise in layoffs as signs of extreme pressure on prices of goods and services.  Specifically, Roubini notes:

signs of stag-deflation now are clear: we are in a severe recession and now the recent readings of both the PPI and the CPI are showing the beginning of deflation. Slack in goods markets with demand falling and supply being excessive (because of years of excessive overinvestment in new capacity in China, Asia and emerging market economies) means lower pricing power of firms and need to cut prices to sell the burgeoning inventory of unsold goods; slack in labor markets with sharp fall in employment and sharp rise in the unemployment rate means lower wage pressures and lower labor cost pressures; and slack in commodity markets – that have already fallen by 30% from their summer peaks and will fall another 20-30% in a global recession – means lower inflation and actual deflationary forces.

Falling prices may sound like a good development for consumers (like gas at $2/gallon instead of $4), however, deflation is a very dangerous animal, far worse than inflation, which is a natural result of economic growth.  Roubini outlines three dangerous effects of price deflation:

1. Wages fall—as demand slips below supply, an employer must cut back costs and production to offset the drop in the prices it can receive for its products;
2. Consumer spending drops—in an environment where prices are constantly falling, consumers have no incentive to spend (think of the housing market, why buy a house today if it is going to lose 10 percent or more of its value over the next year?)—so consumers wait to spend and that reduces demand causing prices to spiral downward;
3. Real interest rates rise—even though the Fed lowers rates to stimulate the economy by making borrowing cheaper, borrowing actually becomes more expensive because future dollars are more expensive than present dollars in a deflationary environment.

Roubini explains the last phenomenon with this example:

Suppose you are a firm or household that had borrowed – say a 10 year mortgage or a 10 year corporate bond – at an interest rate (i) of 5% at the time when inflation (dP/P) was expected to remain at 3%; then the real ex-ante real cost of borrowing (r= i – dP/P) was only 2% (the difference between 5% and the expected inflation of 3%). Now suppose that, ex-post, the economy falls into a deflation trap and prices are now falling at 2% annual rate and expected to fall as much for a number of years. Now the ex-post real interest rate (r= i – dP/P) on that borrowing rises from 2% ex-ante to an actual ex-post 7% (5% – (-2%)). Thus, ex-post unexpected deflation sharply increases the real interest rate faced by borrowers or, equivalently, sharply increases the real ex-post value of their real liabilities (D/P).

Stag-deflation can be prevented, but the new administration is really going to have its hands full trying to battle this monster.  The new economic team will need to be creative, adventurous and proactive.  It may need to reverse policy from time-to-time on a dime.  It may need to be inconsistent.  This is one event where having a plan and conservatively sticking to it may not be the best course, and we, the consumers and investors, are going to need to be patient and cautious.

SOURCE: The Deadly Dirty D-Words: “Deflation”, “Debt Deflation” and “Defaults”. And How Central Banks Will Have to Resort to “Crazy” Policies as We Have Reached Such Bermuda Triangle of a “Liquidity Trap”, Nouriel Roubini, RGEMonitor.com