What is Deflation and Why Should You Care?

There was building sentiment in April that we were headed for another spring slowdown. Unfortunately, last Friday’s GDP report failed to put those concerns to rest as it showed the economy was growing, but more slowly than anticipated, and not fast enough to create meaningful job growth.  This week the Fed announced no changes in rate targets or current stimulus plans saying the economy was growing “at a moderate pace.” But remarkably several usually hawkish (meaning tough on inflation) Fed bank presidents revealed their growing concern over “De”- flation. And just to keep things interesting, today’s jobs report stirred the pot further with a surprise on the upside. Today, we’ll try to make some sense of it all.

As the Federal Reserve is the primary driver of our markets and economy right now, it makes sense to consider these issues according to their priorities; and deflation seems to be their primary concern at the moment. Several Fed bank heads, including Eric  Rosengren, William James Bullard who are traditionally more inflation sensitive expressed concerns about deflation this week.

On Monday the Personal Income and Outlays report showed that an important inflation gauge, very closely watched by the Fed known as the PCE (personal consumer expenditure) continued to decline as is now at a level where it was during the financial crisis. The annual core PCE (which removes oil) is now 1.1%, following last month’s 1.3% and well below the Fed’s target of 2%. In fact all three major inflation gauges are declining.

And the US is certainly not alone in the problem of slowing prices. The Bank of Japan announced that they did not expect to meet their inflation target of 2%. The European Union is falling deeper into recession. Germany, Europe’s largest economy just reported inflation of only 1.1%. So why aren’t falling prices a good thing?

What is Deflation?

Deflation quite simply is a general decline in prices, but its causes can be considerably more complicated. It occurs when the inflation rate falls below zero, so you can begin to see that a 1.1% inflation rate, half of the Fed’s target of 2% is a cause for concern. In fact, the Fed dislikes deflation worse than it dislikes inflation. As Michael Pond, co-head of rate strategy at Barclay’s Capital puts it Chairman Bernanke has said he “is not going to remove stimulus too early” risking leaving it too long, “because they think they know how to control it if the economy is running too fast . . . but they are not sure how to speed it back up if it is too slow.”

Deflation can be caused by a reduction in the supply of money or credit, but that is certainly not the case today. Today’s causes likely stem from a decrease in government, personal and investment spending. Deflation is the opposite of inflation and is worse than inflation for several reasons, but the most important is that is increases unemployment. Companies have to lower prices to compete and ultimately salaries and jobs decline.

Consider this: You are thinking about buying a TV, and because the Super Bowl is many months off, you have some time to shop around. As a wise shopper you have noticed prices falling all around you, at the grocery store, the gas pump, the department store, and especially the electronics store. Logic tells you that if you wait to buy that TV, it will undoubtedly fall in price like everything else – but how long should you wait? You might even wonder if you should buy it at all if prices declines begin to accelerate, and with them, your ability to buy more than necessities.

Deflation creates a vicious cycle of falling profits, closing factories, shrinking employment and incomes. A most insidious danger for modern economies (a primary reason the Fed is concerned) is what happens with debt. You’ve heard it said that borrowing during periods of high inflation allows you to pay your loan back with cheaper dollars. Your loan is fixed, but your income rises and the loan, valued in today’s dollars, becomes ‘cheaper’ relative to future inflated dollars. With deflation, the dynamic works painfully against the borrower. The loan becomes relatively more expensive as the ability to pay declines. The loan value inflates as the dollars available to pay it become more scarce.

With deflation in the fore of the Fed’s concerns, it is a safe bet that QE3 (the buying of Treasuries and mortgages to drive yields down) and low rates will continue for some time to come – easily through the rest of the year, despite the occasional stronger-than-expected jobs report. Not until we see inflation, specifically the PCE measure of inflation, above 2% for a sustained period, should we expect the Fed to back off the stimulus pedal. In fact, expect them to boost QE3 stimulus measures if PCE levels off or declines further.

The stock market is up today on news that the unemployment rate dropped from 7.6% to 7.5% and that the economy created 165,000 jobs in March, more than expected. Stock investors got more good news yesterday as the ECB cut its benchmark lending rate in efforts to stimulate the flagging European economy. Lower interest rates drive investors seeking better returns from low yielding bonds into higher risk assets like stocks.

It was a busy week for economic reports, however they failed to offer any direction, which is in keeping with today’s general theme. Home prices are rising, which is great news for home owners according to the Pending Home Sales and S&P Case-Shiller  reports.

Manufacturing is sputtering according to the national PMI report and two Fed regional reports from Dallas and Chicago. Though there was some good news on the productivity front as nonfarm business productivity rebounded an annualized 0.7%, following a decline of 1.7% in the fourth quarter.

Consumer confidence was up a bit for the month, but the assessment of current conditions was a little weak according to Econoday. Difficulty getting jobs kept a lid on confidence. However, investor confidence does not appear to be held back by the economy as State Street’s confidence index rose 5.5 points to 93.6 this month from a revised 88.1 in March. Econoday says that confidence among North American investors is suddenly over 100, at 105.8 for a more than 10 point gain. A reading over 100 indicates demand for risk. But demand for risk outside North America remains depressed with readings on Europe and Asia.

Given that Washington does not appear terribly interested in reversing or better targeting the cuts in government spending related to the sequester, it looks like the Fed will remain the prime economic catalyst for now. And the Fed appears to be focused squarely on the threat of deflation and are not even close to draining the money tough. So it looks like continued lift for stocks and pressure on bonds for the foreseeable future.

Geoff and I are pleased to announce that in the next few days we will begin posting short articles to our new blog site that will cover a variety of topics ranging from simplifying complicated investment and planning concepts to musings on opportunities available each of us, if we only reach for them. Please subscribe to be notified by email with each new posting.

Have a great weekend.