Deflation threat faint, but worrisome

THE BALTIMORE SUN

For generations, Americans have been riding inflation to a better life. They get a job, buy a house and, over time, accumulate wealth as wages and home values climb.

But what if prices started going down - triggering deflation instead of inflation?

A growing number of economists - even the Federal Reserve - are worrying about that possibility. Many don't expect it to happen, but for the first time in most people's memory, the prospect of deflation is a legitimate concern, experts say.

"Nobody seems to object to a little bit of inflation. That means things are growing," said Ray Ferrara, a financial planner with ProVise Management Group in Clearwater, Fla. "A little bit of inflation will improve the standard of living. A little bit of deflation will lead to a decline in your standard of living."

Deflation is a long period of falling prices that leads to lower profits, lower wages and fewer jobs. It feeds upon itself, with consumers and businesses reluctant to spend or borrow, and the economy languishes.

It can grow out of a lingering economic slump accompanied by high unemployment, and political and economic uncertainties.

Talk about deflation has heated up because prices of a wide array of products, from clothing to electronic gadgets, have been falling for some time. Companies have cut prices to maintain sales in the weak economy. Low-priced foreign goods, particularly from China, where labor is cheap, have forced manufacturers to keep prices down to compete, economists say.

The economy has continued to sputter in recent months, despite repeated attempts by the Fed to spark a revival by cutting interest rates. Last week unemployment hit 6.4 percent, the highest level in more than nine years.

Inflation has shrunk to a 2.3 percent annual rate for the first five months of this year, a level hard to imagine for those who lived through the double-digit inflation of the early 1980s.

Now, some can't help but speculate about what would happen if the rate continued to fall.

"It's just conceptually so foreign. It's like someone is stealing something from you. Deflation would be a tough thing for this country to live with," said Joseph McAlinden, chief investment officer with Morgan Stanley Investment Management in New York.

Not since the Great Depression has the United States experienced full-blown deflation, and in that case, it took heavy government spending during World War II to turn things around.

"You had unemployment up to 25 percent," Ferrara said. "You had people doing everything they could to hold onto their jobs. You had families with every member doing whatever odd jobs they could to have whatever income possible. That's what sustained deflation has done and could do again if it were to happen."

Fed Chairman Alan Greenspan, who is normally cautious in his economic pronouncements, recently warned that while the possibility of deflation is remote, it bears watching because of the serious damage it could do.

'Even feels good at first'

In its opening stages, deflation can be insidious.

"It even feels good at first," said William Greider, national affairs correspondent for The Nation and author of several books on economic policy. "What's wrong with falling prices? That's great."

But, over time, consumers anticipating falling prices would hold off on purchases to get a better deal later. Company profits would be squeezed, and businesses would be forced to cut wages or lay off workers.

Consumers with less money, and even those with plenty of cash, would continue to postpone spending, causing further damage to businesses. More job and wage cuts would follow, and the continuing downward spiral would be difficult to stop.

"If deflation takes hold, companies will cut back. They have no choice," Greider said. "They will try to reduce wages, even if unionized; they will ask for give-backs."

While prices across the board would fall, they wouldn't fall in harmony, experts said. So incomes could fall at a faster clip than, say, health care costs.

Few would escape the pain.

"If they have no debt of any substantial size, and they are in a job that means their wages will keep rising at a normal pace, even though prices are falling, they will be in good shape," Greider said.

"How many people have a job like this? Not very many. How many ordinary households don't have a mortgage and credit card debt and other obligations? ... These people are in trouble."

Nation of debtors

Most experts agree that deflation would be most painful to debtors, and America is a nation of debtors.

"Debt in an inflationary economy is a manageable thing. Debt in a deflationary economy is the kiss of death," said Ferrara, the ProVise financial planner.

In a period of deflation, dollars are worth more tomorrow because they will have more purchasing power as prices keep falling. With inflation, the opposite is true.

Let's say you borrow $10,000 from a friend and the annual inflation rate is 3 percent. A year later, the purchasing power of those dollars has fallen, so when you repay the loan it's more like paying $9,700. In the case of 3 percent annual deflation, the opposite happens. Dollars are worth more, so repaying $10,000 would feel like $10,300 coming out of your pocket.

So, with inflation it makes sense to spend, while with deflation, saving pays off.

Homeowners with large mortgages would struggle under deflation. Many homeowners, recently refinancing to take advantage of low interest rates and rising housing values, have taken out bigger loans.

If you are already struggling to meet a mortgage or rent on your current income, imagine if your wages fell 10 percent to 15 percent, Greider said. "How are you going to handle that?"

Loan defaults would rise, throwing more homes on the market. But fewer people could afford to shop for houses, and housing values would fall along with other prices, Ferrara said.

A homeowner whose house has plunged in value could actually owe more on the mortgage than the house is worth. And if he sold the house, he could end up owing money to the bank.

Nor are investors immune.

"It's going to hammer the stock market," said Barry Strudwick, president of Strudwick Wealth Strategies in Baltimore. "How do you sell stock in an extended period of falling profits?"

Not all stocks would suffer the same. Some companies with little or no debt, or those that provide essentials such as food, would weather deflation better, experts said.

Still, falling stock prices would be crushing to near-retirees who have their 401(k) plans tied up in the market, experts said.

Few places to hide

There are few places for investors to hide.

Cash is king, of course, because money gains in purchasing power. "If you get in a virulent form of deflation, you want something as close as possible to putting the cash in your mattress," said Mark Zandi, chief economist with Economy.com in West Chester, Pa.

A more secure alternative to cash in a mattress might be U.S. government bonds.

"The nice thing about government bonds is the government can't go into bankruptcy," Ferrara said.

Some suggest that investors could park money in higher-paying bonds issued by other countries with stable governments. But others say that if America's looming economy falls into deflation, the rest of the world would probably follow.

If deflation does start, it will be hard to stop. A huge burst of government spending would probably be necessary, experts said. Some joked that the Fed would throw $100 bills from helicopters if that's what it took to get consumers spending again.

"It lasts until the next major shooting war or something like if we decide to colonize the moon," said A. Gary Shilling, an investment adviser and author of Deflation, a 1998 assessment of the threat.

Japan's painful example

Consumers only have to look at Japan to see how painful deflation can be. The world's second-largest economy, in a slump for more than a decade, can't seem to pull itself out.

"The best way to get out is not to get in to begin with," said James Keller, portfolio manager with Pimco, a fixed-income management company in Newport Beach, Calif.

Many economists and money managers say the United States won't follow Japan. Unlike Japan, the United States would be quick to take whatever bitter medicine was required to stave off deflation, they said.

Last month, Greenspan said the policy-makers would lean over backward to prevent falling prices and wages. Concerns about deflation also prompted the Fed last month to cut interest rates for the 13th time since early 2001, sending rates to the lowest level since 1958.

"This is the most inflationary monetary and fiscal policy in the history of the nation. You have interest rates at practically zero," said Peter Ricchiuti, professor of finance at Tulane University in New Orleans. "You're giving money away. You have massive tax cuts."

And it's Americans' nature to spend, said Zane E. Brown, director of fixed income at Lord, Abbett & Co., an investment management firm in Jersey City, N.J. "We respond to any stimulus. Even the prospect of getting a check from the government is enough to justify a weekend shopping trip," Brown said.

Hopeful signs

There are other hopeful signs, economists said. The U.S. economy is recovering, and the falling dollar has eased pressure on U.S. manufacturers to lower prices because of foreign competition, Zandi said.

Still, "people are right to be more afraid of deflation than they would be of inflation. It's a rockier scenario. It's spookier," Ricchiuti said.

With inflation, he said, "you always feel you're losing a little ground, but you don't feel like the game's over. In deflation, nobody would be able to hold their ground."

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