Deflation's Dead Horse Rides Again

The stock market shows that reports of demand's demise are again exaggerated.
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The best evidence that the U.S. isn't headed into a Japan-style quagmire of iterative price contraction is the performance of its primary asset market: the stock exchange.

The dog days of a recession are often fertile ground for certain experts who seem always to believe deflation will eat the economy. And that chorus has predictably risen in light of recent government data showing average prices have actually started falling in the face of waning demand.

But if deflation really were a problem, you'd expect it to bother stock traders, whose assets are denominated in dollars and who'd be among the first to worry if corporate margins were under some kind of transforming, historic threat. So far, it hasn't.

Yawn

Case in point was Friday, when Wall Street shrugged off a

producer price index showing its biggest drop since the government started the index in 1947. The seasonally adjusted plunge of 1.6%, following a 0.4% rise in September, reflected price declines in every category. The core index, a more stable gauge of inflation that excludes volatile food and energy items, fell 0.5% -- its biggest decrease since August 1993.

"The very behavior of the stock market belies the idea there's much risk of deflation," William Dudley, director of U.S. Economic Research at Goldman Sachs, said. Dudley said "worries about deflation are premature," as overall consumer prices are still rising on a year-over-year basis, and the

Federal Reserve "still has ammunition left" to stoke the flailing economy.

Friday saw the

Dow

climb above its Sept. 10 close, capping a comeback in which all three major averages repeatedly ignored bad news to rally on perceptions of better things to come. Before Monday's plane crash, the Dow was up 21% from its Sept. 21 trough, while the

Nasdaq

had risen 32% over the same period.

Meanwhile, many consumer cyclical stocks have outperformed the broader market since Sept. 17. The S&P Hotel Index is up 14.5%, compared with the 7.8% gain in the

S&P 500

. The S&P Department Store Index has soared 24.4%, while the Consumer Electronic Index is up 10.6%. The S&P Auto Index is, however, off 1.4%.

Deconstructing Deflation

Falling prices aren't always bad for the economy, and often cheer investors during downturns because they imply productivity is rising and the decks are clear for interest-rate cuts. Nevertheless, when prices fall because of buckling demand, lower prices are hallmarks of an economic slump.

The danger occurs when producers repeatedly cut prices as an incentive for consumers to spend, which in turn squeezes profit margins and earnings. With expenses usually fixed, the pressure on margins can become intense if prices continually contract, leading to everything from layoffs to debt default.

"It's a mixed message," said Bruce Kasman, chief U.S. economist at Goldman Sachs. "It's a story of falling input prices, which is good, and a story of pressures on corporate profit margins and the lack of pricing power, which is less good from the perspective of where we stand."

The manufacturing sector -- still the economy's weakest link -- has been in a recession for a year, and economists don't see a turnaround before the middle of 2002. Industrial prices are "under the most severe downward pressure," said Josh Feinman, chief economist at Deutsche Asset Management, because of sluggish demand, which was exacerbated by the terrorist attacks.

According to Friday's report, prices for capital equipment dropped 0.7% in October, after edging up 0.1% a month ago. Meanwhile, the PPI for intermediate materials, supplies and components also fell despite rising in the previous month. The indices for nondurable manufacturing materials, durable manufacturing materials, materials and components for construction, as well as intermediate foods, fell at a faster rate in October than September.

Harder to reckon is the steady drumbeat of layoffs, which on one hand show companies are making hard decisions to protect margins, but at the same time cause further erosion on the demand side. "That's probably the most scary part of the whole process," said Dudley. "If all businesses shed costs then all you end up with is a weaker economy," he said. "You have a vicious cycle that the Fed is trying to break or at least slow down by easing aggressively."

"I wouldn't read too much into the PPI numbers," said Rick MacDonald, economist at Standard & Poor's MMS. MacDonald believes the drop in PPI is probably related to a temporary slowdown in demand following the attacks and that it could "be a one or two month adjustment process that takes place in order to get supply and demand into better balance." Prices would "stabilize at these lower levels going forward," he said, noting that inventory levels in manufacturing are at manageable levels.

"It just suggests that rather than deflation being a huge concern, disinflationary pressure's building," MacDonald said. "The good news is it gives the Fed a little more room if it wants to ease rates a little more."