Lately, both the producer price index and the consumer price index have been showing possible signs of deflationary forces taking hold in terms of lower prices for goods and services, with consumer prices dipping slightly for three consecutive months. However, so far, even with the significant declines in home prices, we have not experienced anywhere near what happened to prices during the Great Depression.
All of us, save a very few, have lived only in times where inflation was the greatest concern to investors and deflation was a legend—existing more in mythology than fact. Employees generally expect their wages to increase to, at least, keep ahead of inflation, and since prices for goods and services generally increase, companies have the dollars to afford the wage hikes. Using monetary policy to keep inflation in check while allowing the economy room and liquidity to grow has been the Federal Reserve Board’s main job for decades.
Every once in a while though, economic imbalances (i.e., massive debts in some countries countered by massive surpluses in others) can build to a point where consumers run short of liquidity in their personal finances to continue to make purchases at a rate that would continue to grow gross domestic product. Consumers then get choosy about what they buy and at what price the buy the product. As demand slows, prices stagnate and, in some cases, begin to drop as inventories pile up. Not all consumers jump at the initial price, but rather, they wait to see if the price falls further. As prices drop, and companies earn less on their products and services, wages and jobs drop, too, which makes consumers more nervous about their economic future, forcing them to cut back on spending even more. The deflationary cycle thus continues until economic forces come back into balance.
This is why investors should be more concerned about deflation than inflation, for deflation is not kind to companies, and thus equities. That said, Casey B. Mulligan, Professor of Economics at the University of Chicago, recently pointed out in the New York Times blog, Economix, that the deflation in the U.S. in 2008, and what may be building now, is nothing compared to deflation during the Great Depression.
In the spring and summer of 1929, consumer prices, especially commodities, were on the rise. Thus, banks were heavily lending to farmers as the price for their crops was increasing (this was before farmers could use futures contracts to lock-in the price of their crops ahead of season). However, “In the fall of 1929, the inflation stopped and prices headed down (incidentally, that’s when the Great Depression began), falling almost every month for nearly four years. By the summer of 1931, when the Depression was about two years old, this deflation had brought prices down almost 13 percent from their 1929 peak. It was difficult for homeowners and farmers to make mortgage payments as their income fell sharply.”
By contrast, the deflationary spell that begin in October 2008 as the credit crisis hit its peak lasted only a couple of months before inflation returned. One of the biggest differences between these two periods, though, is the government’s response. At the outset of the Great Depression, the Federal Reserve, misreading the problem, raised the target federal funds rate, thus choking off liquidity and exacerbating the deflation in prices. In 2008 and since, the Fed has responded by providing huge volumes of liquidity to markets, including lowering the federal funds rate target to a range between 0 and 0.25 percent and using its own balance sheet to buy mortgage-backed securities and support credit markets. So, with the amount of money bring injected into the economy, seeing deflation reverse to inflation so quickly may not be surprising.
However, with the recent trend that may be forming toward lower prices, and continued hemorrhaging in the housing market, it is unclear whether the Fed has staved off a Great Depression-like deflation. Has the Fed been successful or merely kicked the can down the road? What happens if deflation sets in with the Fed already having provided as much liquidity as it can? What would it do then? These are tough questions with no clear answers, but investors must find a way to be prepared, just in case.
Gregg D. Killoren
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