…The Committee perceives that over the next few quarters the upside and downside risks to the attainment of sustainable growth are roughly equal. In contrast, over the same period, the probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its already low level. The Committee believes that, taken together, the balance of risks to achieving its goals is weighted toward weakness over the foreseeable future. -- Federal Open Market Committee Statement, May 6, 2003
Alan Greenspan and the rest of the Federal Reserve's Open Market Committee stunned the financial markets with their press release this past May 6th. The discourse over deflation has moved from the realm of theoretical musings to that of policy debate.
Fuelling deflation fears were the Producer Price Index (PPI) and Consumer Price Index (CPI) reports for April that were released this week. Both were in negative territory, giving credence to the Fed's deflationary fears. The PPI for April declined 1.9%. Even excluding food and energy, the decline was nearly a full percentage point at -0.9%. The goods that declined the most were passenger cars, light trucks, and cigarettes. The reason that autos and light trucks led the decline in price is simple - too much supply. When supply exceeds demand, prices fall. The U.S. auto industry is one sector of the economy that appears to be in full blown deflation.
The oversupply of automobiles, (or the collapse in demand for autos, depending on your point of view), spurred the auto manufacturers to begin cutting prices to increase demand. They primarily did this through 0% financing and other incentives. Initially this worked, auto sales did rebound somewhat. But the supply-demand imbalance has not been fully corrected. Auto inventories are at an all time high.1 The incentives, originally a temporary offer, have been extended and extended again. Loan periods are being extended to lower monthly payments.2 Now consumers are putting off purchases in the expectation that prices will continue to fall. This prompts automakers to cut prices again to increase sales. This behavioral cycle is deflation in action. It is a deflationary spiral, and its here in the United States.
This imbalance will not last forever. Production will eventually be reduced. Demand will eventually recover. The free market will work. But first there will be pain. There will be layoffs and plant closings. It may take time, but equilibrium will return. The question is, how long will it take? In the case of Japan it has been over 10 years and counting. Japan is the poster child for deflation. Japan has survived a stock market bubble a real estate bubble (both deflationary events), and has been at negative real interest rates for several years in an effort to reverse the trend. Yet prices in the first quarter of this year dropped 3.5% from a year ago, a new record.3
Back in the U.S., the most recent Consumer Price Index also carries the deflation story, although not quite as startling as the below-zero PPI headline number. Still the 12 month growth in the CPI (+1.5%) was the lowest CPI reading since 1966. The CPI readings (excluding food and energy) since the beginning of the year have been anaemic. The first four months of the year posted readings of +0.1%, +0.1%, +0.0%, and +0.0%. Compounding the readings from the three months ending April 2003 produces an annual rate of just 0.4%, suggesting that the record 1.5% annual growth rate may fall further.
Looking closer at the CPI reveals the bipolar nature of today's economy. Details in the auto sector confirm the PPI data - prices falling sharply. Prices for new vehicles fell 0.4% in April and are down -1.2% from one year ago. Prices for used cars and trucks fell 0.3% in April and are down -2.2% from 12 months ago. Yet prices in a few other sectors are clearly rising. Medical care costs are 4.0% higher than a year ago. Prices for education tuition and fees are a whopping 6.5% higher than April 2002.
Costs for businesses have been accelerating as well. Costs for health insurance, workers compensation, and liability insurance have been rising for most industries over the last year. Insurance premiums in general declined during the late 1990's as investment growth exceeded projections and allowed insurance companies to use these gains to lower premiums and gain market share. The bear market in equities as well as low bond yields have removed this cushion. Also, the terrorist attacks of Sep. 11th, 2001 have caused the insurance industry to re-evaluate their policies on terrorism and the 'act of war' clause inherent in nearly every insurance policy.4 The end result of all these factors is higher premiums, which to businesses, results in higher costs that they may or may not be able to pass along in higher prices, depending on the conditions in their specific industry.
Today's economy is segmented. Some areas are experiencing genuine deflation; and some have significant pricing power and are able to pass on increased costs (and possibly a bit more) to their customers. The examples discussed so far seem to be the extreme cases. Most segments of the economy are somewhere between these extremes. But overall, the trend of prices is downward. The trend is severe enough that the Federal Reserve is not only concerned about it, but it has vocalized its concern.
Furthermore, based on the Fed's statement, it appears that they are very committed to preventing/defeating deflation. Given the choice between deflation and inflation, it seems clear that they will lean toward inflation. Federal Governor Bernanke has even stated that the Fed would use its "printing press" to print money in an effort to prevent deflation.5 Several other speaking engagements by Fed officials have reinforced the fact that the Fed is much more concerned with deflation than inflation. After all, former Fed Chairman Volker has demonstrated conclusively to central bankers that the correct prescription for inflation was to follow his example (ratchet interest rates higher and higher until inflation loses the fight). Deflation, on the other hand, is a completely different animal altogether. Given a choice of the two, the Fed would much rather deal with the devil it knows than the devil it doesn't know.
So where does that leave us as investors in this bipolar economy? I suppose that it depends on if our outlook is more in the deflation camp or the inflation camp. For the deflationists, bonds are the place to be. Deflation means that a dollar tomorrow is worth more than a dollar today. This benefits creditors, not debtors. In this scenario, bonds should increase in value.
Of course, if you cannot trust a country's central bank to devalue a currency when they say they will, who can you trust? When the Fed says that they will, in effect, print as many dollars as it takes to inflate the currency, then why bet against them? Well, the answer lies in your view of timing. Investors who prefer the inflation side of the debate may be able to minimize their pain in cash, gold, or commodities.
There is a battle underway in the economy. It is the forces of deflation versus the forces of inflation. No one knows which will win, or how long it will take. Of course, timing is everything. If deflation gains the upper hand, debtors will be the clear losers. As currency becomes more valuable, those that owe yesterday's (cheaper) dollars to creditors will end up paying more than they would have if inflation had dominated. They will pay yesterday's debts with today's more valuable dollars. The flip side of the situation will be bond investors, who should benefit somewhat from deflation (ignoring the fact that deflation will likely hurt the economy as a whole). Bonds may appreciate in value.
Another aspect to consider is your own personal debt level. If strong and persistent inflation does return (not likely in the near term, in my opinion), debtors should benefit at the expense of creditors. This is because creditors will be repaid with future dollars that have less purchasing power. However, in the event that inflation remains flat, or that deflation dominates, then it may be a prudent time to reduce your own personal debt.
Which side will win - inflation or deflation? Unfortunately, there is no way of knowing with certainty. From the statements emanating from the Fed, I think that they will err on the side of inflation rather than the uncertainty of a deflationary scenario. The most likely scenario for the economy is the middle road - neither Japan-style deflation nor 1970's-era inflation. In my view, the prudent action is to prepare for both scenarios by structuring your investments accordingly.
A good method to gauge the battle is to watch the bond market. Following this week's deflationary scare, bonds rallied. I expect bonds to fall somewhat as deflationary fears recede, and then to rally again if further deflationary evidence unfolds. If and when inflation takes the upper hand, bonds prices should decline. As such, the price of bonds should provide an indicator as to how this battle between the bipolar economy unfolds.
1. McCracken, Jeffrey; Vehicle Backlog Hits New Highs Detroit Free Press May 14,. 2003.
2. Ellis, Michael; GM expands incentives with six-year loans. Reuters. May 16, 2003.
3. Wiggins, Jenny; Despeignes, Peronet; Pilling, David Fears Grow that US Economy Faces Deflation Financial Times May 16, 2003.
4. Insurance Journal Workers' Comp Market Analysis Shows Remarkable Improvement for Combined Ratio; Fall in Investment Income Insurance Journal. May 16, 2003.
5. Speech by Federal Governor Ben Bernanke before the National Economists Club, Washington, DC. November 21, 2002.