Stop Worrying About Deflation

The Federal Reserve is running its monetary printing press day and night, desperately seeking to inflate the U.S. dollar. It may have accomplished its goal, at least outside the U.S. Oil, which is traded in dollars, has risen sharply in the past few months (starting well before the Arab unrest). Food prices worldwide have also risen. Global supply of food hasn't fallen. But increased demand for meat, poultry and other higher status foods, especially in China and the rest of the developing world, has strained supplies of grain, and pushed up the price of bread. It's probably no accident that the unrest in the Arab world was preceded by rising bread prices. It's tough to be complacent if you and your family are having trouble getting enough to eat.

In America, there seems to be little inflation. The Fed worries that deflation, even though it's not actually occurring, would lead consumers, hoping for lower prices later, to hold back on spending and retard the economic recovery. It asserts that Japan's meandering price levels are a cause for its economic stagnation. So the Fed keeps shoving bales of dollars off its loading dock. But this is a misadventure in misjudgment.

First, deflation today would help consumers. Household incomes have hardly risen for decades, and consumers react to higher prices by cutting back, not spending more. Rising gasoline and food prices discourage discretionary expenditures. Some people may swap a fuel hog for a gas sipper. But most can't afford to do that, so they just spend less on other things. Price deflation would increase their spending power and lift demand.

The last period of sustained deflation was in the 1930s. But that deflation was the result of the economic downturn, not the cause. Speculative financial and real estate bubbles, aggravated by misguided monetary policies, caused the Great Depression. Did deflation retard recovery from the Great Depression? There's not a lot of evidence of that. Joblessness, by all indications, was the primary factor holding the economy back. When employment rose as America geared up for World War II, consumer spending rose. (It was partially delayed by rationing during World War II, but there was a surge of consumer spending as the war ended which led to the postwar prosperity.)

Sustained deflation also took place during the Gilded Age (1865-1900), when prices dropped by roughly one third. This was a period of great economic growth. Although punctuated by financial bubbles and sharp recessions, the Gilded Age saw dazzling technological innovation (construction of municipal electrical energy systems, the telephone, improved steel manufacturing and oil refining, etc.), legal innovation (evolution of the general business corporation), and financial innovation (nationwide capital markets that featured vibrant secondary markets in common stock and corporate bonds). All this innovation spurred enormous growth. Income distribution was problematic, as business elites accumulated vast fortunes, often by forming cartels and monopolies, while workers struggled to get living wages and farmers combated monopolistic railroad freight rates. Price deflation was a gift to ordinary Americans trying to survive. The growth of mass market mail order retailers, like Sears Roebuck and Montgomery Wards, signaled that Americans of this era had little aversion to consumption in spite of falling prices.

The way the Fed measures inflation tints the lenses through which it sees a threat of deflation. The Fed's preferred benchmark is the Personal Consumption Expenditures Price Index (PCE). The better known Consumer Price Index measures changes in price of certain selected consumer items. For example, the CPI measures inflation or deflation in the price of name brand coffee by comparing the current price of that coffee against its past price. By contrast, the PCE incorporates substitution of products by consumers. If the price of name brand coffee rises, and consumers switch to less expensive supermarket house brand coffee, the PCE records lower inflation than the CPI because consumers avoided paying the price increase in name brand coffee by switching to lower cost house brand. The fact that drinking house brand coffee can sometimes be a near death experience isn't counted as inflation.

The PCE typically records about one-third less inflation than the CPI. So by focusing on the PCE, the Fed sees a greater potential for deflation. But the Fed's use of the PCE means that a reduction in living standards in response to rising prices doesn't count in the measurement of inflation. That notion would be a hard sell to shoppers facing the daily realities revealed on grocery store shelves. It also means that the harder the Fed tries to instill inflation, the lower it might push living standards as consumers substitute cheaper and cheaper goods when their preferred choices become costlier as a result of Fed inflating. Perhaps the Fed should consider that forcing people to substitute sawdust for bread might snatch defeat from the jaws of victory.

The primary reason why people consume or don't is confidence in the future. Moribund consumption in Japan is due to Japan's uncertain future. Younger Japanese adults face dismal employment prospects, often limited to temporary jobs instead of the lifetime employment contracts given their parents. Since younger adults tend to consume with vigor, their lousy employment picture dampens economic growth. (Older Japanese are actually spending more as they tap into their savings for retirement, but this hasn't made up for the reticence of the young.)

No matter how much the Fed inflates prices in America, people won't consume deliriously if they fear layoffs. Using your old washer and dryer for a while longer makes sense of you're trying to reduce debt and build up an emergency cash fund. Spending like the maniacal days of 2005 doesn't make sense if your house looks like it's headed for a double dip in value. The Fed thinks that rising prices will scare people into spending. Rising prices do scare people. But, in these uncertain times, they scare people into pulling back. A little deflation would come as a relief.

The Federal Reserve Fighting Market Forces

Every year, in late August, financial regulators, academic and private industry economists, and the like gather in Jackson Hole, Wyoming, for a talkfest. This year, Fed Chairman Ben Bernanke will speak on Friday (Aug. 27), and will probably announce more quantitative easing. That would mean further efforts to lower medium and long term interest rates (the Fed has already lowered short term rates to zero). What, technically speaking, the Fed will do remains to be seen. But the goal is to prevent deflation.

Policy makers tell us to shrink from the horrors of deflation. Consumers, we are told, will stop buying in anticipation of lower prices. Holders of capital will stop investing, hoping for better deals later. Home values will sag, discouraging consumption all the more. The nation will sink into another Great Depression.

One problem: that describes current conditions. People have cut back on consumption. Holders of capital (at least individuals who tend to be long term investors) are fleeing the stock market. Real estate prices are stagnant or falling in most of the country. We're not in another Great Depression. But we already have deflationary behavior.

Another problem: deflationary behavior makes sense. With unemployment high and not falling in a meaningful way, it's rational to spend less and save more. People have relearned the age-old lesson that debt is undesirable, and they're deleveraging. Private industry is hoarding cash, as are the big banks, to have a fallback in case the economy fades again. There are still so many bad home loans outstanding, and so many foreclosed houses, that real estate prices can't rise significantly, not for years to come.

The prosperity from the early 1980s to 2008 was built on an ever expanding cushion of credit. Credit spurred home values to rise, allowed consumers to raise their living standards even as their incomes stagnated, and puffed up stock and other asset prices. Credit became the cure for all problems economic. That is, until it was used well beyond the limit of its logic and the credit bubble burst. Deleveraging set in, and still continues. Asset values are falling--as they should in a time of deleveraging. Consumers are cutting back, which is a logical consequence of deleveraging. Our current stagnation is understandable. It's just the result of market forces in operation.

The Fed is trying to fight the market. It's printing money to keep asset values inflated. It's bought a ton of mortgage-backed assets in order to support real estate values. It's essentially given the big banks a big subsidy so the banks can continue to support, through lending, market making and trading operations, the values of all kinds of asset classes.

Any experienced Wall Street trader knows you can't fight the market. The market always wins in the end. Deflation may not be pretty, but it's a natural result of the bursting of a credit bubble. Deflation pushes prices down, but at some point consumers see bargains they can't pass up. Investors see stock values they genuinely find attractive. When home prices fall far enough, plenty of buyers will qualify for loans even with today's stringent credit standards. Demand will revive, as will the economy.

By substituting monetary policy for market forces, the Fed is creating an artifice, where people hold back because they know current prices aren't right. They fear that buying now means losses tomorrow. The more the Fed delays the operation of the market, the longer people hold back. Eventually, they may permanently embrace parsimony. In the capital markets, no one wants to invest long term because they can't believe current prices are solid. Individual investors head for the hills, while professional investors clog up the markets with low risk, high speed trading and other short term speculation financed with the Fed's bargain basement interest rates. No one is embracing risk. Everyone's running from it. On a certain level, the Fed's interventions create deflationary behavior.

The mother of all quantitative eases has been taking place in Japan, and it hasn't worked. Japan's stock and real estate markets have deflated, while its structural unemployment has risen. Japan isn't in a Great Depression. But it can't pull itself out of the quagmire. Market forces were blocked from normal operation in Japan, and now Japan's economy doesn't function well.

America isn't Japan, but market forces are the same worldwide. The Fed can't suppress the market forces pushing America toward deflation. Maybe it can mask their impact to some degree. But the Fed's relentless printing of money is bound to distort markets, asset values and capital allocation. Deflation isn't pretty, and for the unemployed, it's a Depression. But deflationary behavior today is rational, and the Fed wants people to act contrary to their sensibilities. If the Fed doesn't allow market forces to operate, what exactly is supposed to happen? What's the substitute game plan? Does anyone really know?