Disinflation/Inflation/Deflation and Fiscal Stimulus: A Look at 2009

On December 12, 2008, the Bureau of Labor Statistics of the U.S. Department of Labor announced that the Producer Price Index (PPI) for Finished Goods dropped 2.2 percent in November.  This decline follows recent decreases in PPI of 2.8 percent in October and 0.4 percent in September. Food prices were flat and energy prices declined by 11.2 percent.  If one removes the prices for food and energy goods from the equation, as the government likes to do because those prices are considered to be too volatile to rely on them for long-term policy decisions, the PPI increased 0.1 percent.  The other economic news of the day was a report that retail sales fell 1.8 percent in November, a record fifth consecutive monthly decline.

What these numbers are reflecting is that the U.S. economy is experiencing disinflation, and not yet deflation.  There is still inflation (the “core” PPI increased), but its impact is lessening over time, particularly as commodity and energy prices have dropped. Deflation is a condition where the prices of all assets classes decline, usually because the money supply has been restricted.  Part of what makes deflation so devastating to an economy is that it discourages investment.  Imagine a world where every asset one buys almost immediately decreases in value.  In other words, imagine if the only investment option, other than holding cash, was to buy a car.  Wouldn’t one rather hold cash than invest in an asset that immediately loses upwards of 10 percent of its value, and continues to drop over time?  That is what deflation does to investing.  It makes every asset look like a car.

The U.S. economy may be heading toward deflation if the money the U.S. government and other countries have pumped into the financial system does not find its way into the hands of businesses and consumers, or does so at such high cost as to make borrowing unattractive.  The sheer volume of efforts made by governments, and, in particular, those yet to be made by the next U.S. administration, will likely postpone deflation in 2009.  However, central banks will have to shoot their way out of the liquidity trap that has been forming (see my previous post).

Let’s put some quick numbers on this to demonstrate what next year may look like.  Analysts at RGE Monitor calculate that the combination of the negative wealth effect of the drop in housing and a return to the 1990s’ savings rate of approximately 6 percent would result in a decline in consumption over time of more than $1 trillion.  Specifically, if housing prices return to their long-term trend line, that would be roughly a 30 percent drop from peak to trough.  The negative wealth effect from such a drop would subtract approximately $400-500 billion from private consumption over time.  The rebalancing from a debt-oriented consumer to a savings-oriented consumer would reduce consumption by $1 trillion.  A fiscal stimulus plan, like the one outlined by President-elect Obama, that would invest in infrastructure, public services and green technology would greatly help toward offsetting the lost consumption, and since it is not simply pumping money into the financial system, it avoids, and hopefully resolves, the liquidity trap.  However, just to keep the economy limping along, such a program would have to be at least $700 billion.

Even if such a fiscal stimulus package were to be enacted, and it almost certainly will be, we cannot expect that it will end the recession.  But, it will forestall deflation for now.  The hidden danger in such a plan is that it will reinflate the commodity bubble, especially in oil and metals.  In fact, in the recent run-up to what was expected to be an auto industry bailout, oil and iron ore sprang up off their lows.  A spike in commodities next year, along with the large increase in the money supply and low interest rates (probably at zero) would instantly spark inflation, which, in turn, would likely snuff out any economic recovery within a few months.  It would be too soon for the Fed to raise rates to temper inflation because private investment in the economy would not have returned.  Then, in 2010, after the commodity bubble bursts once again, the U.S. economy would turn deflationary, and there would be no stopping it.  This is but one possible outcome, and there are many variables involved, and a change in any one of those variables would have a meaningful effect on the outcome.

What we should be watching next year, then, are the prices of oil and copper.  Both are key elements in any recovery, and with a stimulus plan focused on infrastructure, both will be in demand.  If those prices rise too far and too fast, we will wind up in a “Groundhog Day”-type scenario, where the stock market and commodities prices peak in May/June and then spend the rest of the year falling, just like this year.  The only difference is that the fall will be from a lower high (10,000 to 11,000 on the Dow ones Industrial Average, and $80-100 per barrel of oil) and will result in a much lower low (5,000-6,000 on the Dow, $25-35 per barrel of oil).  Now, on the bright side, if commodities prices manage to move within a reasonable range, the recession may ease, and while the bear market will persist, volatility would come down and thus, the lows of November 2008 would likely represent the bottom.