Imagine a world where prices of all sorts of goods and services just keep moving down.
Your weekly grocery bill shrinks. Your hairstylist gladly accepts 15% less, just to get the business. At long last, movie theaters even stop gouging you on popcorn.
Good times? Sure — until your employer cuts your salary or fires you to cope with the need to reduce prices. Suddenly, the economy is in the grip of a vicious spiral, as falling consumption forces prices lower, driving unemployment up, which in turn drives consumption and prices down further.
That’s the deflation scenario that has, yet again, become one of the hottest topics on Wall Street.
Fear of a broad-based, sustained decline in prices — the textbook definition of deflation — was rampant at the height of the credit crisis in late 2008.
That concern faded last year as the economy and financial markets recovered. By early this year many big investors were warning of the opposite risk: They saw the continued ballooning of government budget deficits, and central banks’ easy-money policies, as setting the scene for an eventual surge in inflation.
Now, we’ve come full circle: With the U.S. economy clearly slowing, deflation worries have revived.
“The U.S. economy is at the doorstep of deflation,” Nomura Securities economist Zach Pandl warned clients in a lengthy report this month.
A number of Federal Reserve officials have echoed that concern in recent weeks, although in the usual Fed manner — i.e., without using an alarmist tone.
For the moment, however, the story still is one of disinflation rather than deflation. Prices overall are rising, but the year-over-year rate of increase has fallen sharply since August 2008.
The government’s consumer price index for June, reported Friday, showed that core inflation — prices for everything except food and energy — was up 0.9% from a year earlier, the slowest pace in 44 years.
Still, the core CPI rose 0.2% in June from May, the biggest monthly increase since October. Prices of used cars, clothing and medical care rose at a faster rate last month than the previous month.
No wonder the average consumer will wonder what this deflation chatter is about. People aren’t seeing it in most of what they buy.
But with the year-over-year core CPI skating closer to zero, the risk is that a slowing economy could tip the scales to deflation.
Optimism about the recovery suffered another blow Friday, when the Reuters/University of Michigan national consumer confidence index for July fell more than expected, to the lowest level since August.
It matters more what people actually do with their money than what they say about their confidence or lack of it. But plummeting confidence preceded the financial crisis and economic crash of late 2008. And the government’s report this week of disappointing June retail sales added to concerns that consumers’ willingness or ability to spend is waning.
Revitalizing consumption has been the great challenge all along in the wake of the devastating recession, of course. A large chunk of the global economy’s capacity to produce goods and services has been idled since 2007. That means many businesses’ pricing power already is severely limited. If demand falls again, serious price-cutting may be the only option companies would have to try to maintain sales.
“A renewed downturn in the economy at the current low level of resource utilization opens up the possibility that disinflation will turn into outright deflation,” said Steven Ricchiuto, an economist at Mizuho Securities USA in New York.
So what? If you have a job, plenty of cash and relatively little debt, deflation would be paradise. Many of your favorite things would cost less. What could be better?
If you’re heavily in debt, however, deflation would make that load even more onerous.
What’s more, the deflation scenario terrifies companies, governments and central bankers because it raises the possibility of a downward economic spiral that can’t easily be reversed.
If consumers adopt a deflationary mind-set, and figure that prices will only get cheaper if they wait to buy, they’ll probably be right. But the end result could be a recession even worse than the one we just climbed out of, if demand sinks and companies react in part by slashing their payrolls again.
That is why deflation and depression often are mentioned in the same breath in economic discussions. From July 1929 to March 1933, as the Great Depression deepened, U.S. consumer prices plummeted 27%.
If we look to financial markets today for guidance on deflation risks, the messages aren’t encouraging. U.S. stock prices have tumbled since April, when worries about the economy began to intensify. Rally attempts have just given way to more selling, as on Friday, when the Dow industrials slumped 261 points, or 2.5%, to 10,097.
Gold, considered the classic inflation hedge, has fallen 5.5% since reaching an all-time high in mid-June.
And the one asset likely to be coveted in a deflationary period — Treasury bonds, with their guaranteed interest — has seen ravenous demand for the last three months. The 10-year T-note yield has fallen below 3% in recent weeks for the first time since April 2009.
Skating Dangerously Close to Deflation – Tom Petruno, Los Angeles Times
What the bond guru sees coming
What about the possibility of deflation occurring?
We’re in a struggle between inflation and deflation right now. We may never get to a negative consumer price index, but the danger is a drop in asset prices and the destruction of credit. It means corporate bonds defaulting because companies aren’t getting enough business and they can’t pay off their debts. It means foreign governments defaulting. It’s individuals with mortgages who can’t get out from under their 16 tons of debt. The economy can’t recover, and unemployment stays high. Stocks would be in trouble because some companies would be going bankrupt while others couldn’t get the credit they need to grow.
So which is the bigger risk now — inflation or deflation?
Our investment committee has sketched out four possible scenarios. Scenario A is that the global economy rebounds back to past levels of high growth. B is just a decent rebound. C is that new normal — half-sized growth. And D is deflation, debt, destruction. I’d say we’re at a C — right now. We believe in the new normal, but what we’re seeing in Europe puts the minus on that C grade.
What does the “new normal” mean for our readers?
Instead of 10% returns for stocks, look for five or so. And instead of the past 20 years’ returns on bonds, which are actually better than stocks — close to double digits — it’s 4% going forward. So that’s what the new normal is. And it’s based upon the primary assumptions of a deleveraging of the private sector and the public sector being limited in what it can spend.
If stocks might return just a percentage point or two over bonds, does that justify the risk?
Barely.
Why is it so hard to get growth going?
The lack of what economists call aggregate demand. So much of the world’s growth and financial surplus have shifted to Asia, where people are fixated on saving instead of buying. Consumption in China is just 35% of GDP, half our rate.
What should investors make of the Fed’s policy of keeping rates close to zero?
The Federal Reserve wants your readers and Pimco to make a choice. You get almost nothing if you hold short-term Treasury bills. The Fed wants you and Pimco to buy the assets that were depressed 18 months ago — stocks, high-yield bonds, etc. — to restimulate the economy. Because this economy has been based on asset appreciation.
Are those the right policy moves? It seems as if we’re just maintaining America’s dependence on high asset values and debt.
I think it’s the only choice, although there’s debate here. You have people like economist Paul Krugman on one side who suggest we must do whatever is necessary to avoid deflation. Advocates on the other side basically echo what Treasury Secretary Andrew Mellon said at the start of the Depression, that we have to liquidate — let real estate, asset values, and wages fall — and then we can start to grow again. I’ve always felt that if you did that, if you liquidated everything, then optimism, the necessary ingredient for successful capitalism, would completely be eliminated.
At the same time, I admit we should have stopped the habit of debt and asset appreciation long ago. We didn’t. Too bad. But at this point what the Fed wants, what the Treasury wants, what the European Union wants, is for the economy to renormalize, so that governments can play lesser roles, and the private sector can do its thing.
If the biggest dangers are overseas, does it still make sense to diversify your portfolio globally?
Yes, definitely. As a bond investor, however, the problem is that many parts of the world that are doing well and will probably continue to do relatively well — China, much of Asia, Brazil — don’t have developed credit markets. We’ve been buying Brazilian bonds hand over fist. Brazil has low debt, and it has really high interest rates. But an individual would have a hard time doing that. Investors can’t buy a Chinese bond — their debt is internalized. But you can also diversify by investing in developing-market equities.
States and cities are going broke left and right. Should investors be worried about muni bonds?
Warren Buffett, as usual, zeroed in on this. It all depends on whether or not the federal government rescues the states. It has done it in the past 12 to 18 months, with stimulus packages, with Medicaid and education grants, and so on. And Obama is proposing more help.
So you’re suggesting there might be an opportunity there?
At the moment, the Republican orthodoxy is gaining sway, so the administration has to be careful as to what checks it writes. But I can’t imagine California, Illinois, or New Jersey going under. We’ve been buying some taxable munis. We bought New York City bonds last week, which gets us a 6.5% yield.
That’s a nice yield, but overall this “new normal” of low returns won’t be much fun.
The important thing to recognize is that if you’re looking for 10% returns to pay for college or to retire on, they’re not going to be there. We’ve been an asset-growth-based economy for so long. We’ve skimmed off the top, living off second and third mortgages on homes, and capital gains on stocks and even on bonds. Now instead of having money work for you, you’ve got to work for your money.
What Bill Gross Sees Coming
- Pat Regnier, CNNMoney