A Whiff of Deflation

The Producer Price Index declined in July, surprising economists who had expected a modest increase. The weakness in producer prices is not new, though. The PPI has been declining on a year-over-year basis since last September. And weakness in prices has not been confined to wholesale prices either: The CPI, while not declining, has decelerated sharply. The most recent year-over-year increase in consumer prices was a mere 1.1%. These levels are very unusual -- you have to go back to the 1960s to find comparable inflation rates.

Arguably, U.S. consumers are not used to operating in a world of declining prices. It seems quite plausible that current consumption levels are being artificially stimulated because consumers are snapping up goods that they perceive to be offered at "low" prices. In other words, consumers believe they should buy now before prices go back up to their "normal" levels.

If deflation is truly upon us, however, such consumer behavior will not continue. Quite to the contrary, if prices continue to fall, consumers may begin delaying purchases in anticipation of still lower prices in the future.

Deflation has negative implications for corporate profitability because it is difficult for employers to lower wages to match the lower prices they are receiving for their products. Indeed the current year-over-year increase in the Employment Cost Index is approximately 4%, well above the increase in the price of finished goods. Negative implications for corporate profits have, in turn, adverse implications for employment levels. The inability to lower wages in a deflationary environment is the classic trap that Keynes worried could lead to incurable economic depression.

These thoughts must be very much on the minds of Federal Reserve officials as they prepare to meet this week. Strong rallies in the U.S. equity market last week were supposedly driven by the belief that the Fed will lower rates even further in light of recent weak economic data. Lower rates do put more money in consumers' pockets through lower mortgage payments. But whether this will cure the situation is a more difficult call. Lower mortgage rates tend to be a one-time stimulus. Priming the pump sometimes starts the motor, but not always.

Lower mortgage rates may also be contributing to an unsustainable boom in property prices as property prices are raised to reflect the fact that financing is less expensive. While recovering from the collapse of the equity valuation bubble, we are not well served to create another asset valuation bubble that will have to be corrected in real estate.

Deflation, of course, is simply the mirror image of inflation: Aggregate demand is insufficient, relative to aggregate supply. Deflation and inflation have had short-term causes such as normal economic cycles. Wars often cause inflation and see deflation in their aftermath.

Longer inflationary and deflationary trends are more mysterious. David Fischer wrote a good book back in 1996 titled "The Great Wave: Price Revolutions and the Rhythm of History" that looked at inflationary waves throughout time. Fischer rejects the idea that there is a single recurring cause for long cycles in price growth. He points out that systematic increases and decreases in demand can have psychological as well as physical causes.

It is not hard to identify long-term forces that may be having deflationary influences now. On the demand side, it remains to be seen whether the global aging of populations in developed countries will be a deflationary force. Do older populations consume as much? Japan, which is ahead of us on the "gray" wave, has seen anemic consumption for some time.

On the supply side, technological advances have, broadly speaking, increased our ability to produce. However, technological advances also create new demand for products that didn't exist before, so their net impact is not straightforward.

If the long-term causes of deflation are structural, history suggests that the Federal Reserve may not be able to "fix" the problem. They can avoid making transition to the new regime more painful than need be by implementing monetary policy that is consistent with the current environment. But if aggregate demand is truly decelerating, simply printing more money will not change that. Thus, the stock market's celebration of a new rate cut may be ill considered.

Admittedly, all of this speculation might be well off the mark -- perhaps we will not see true sustained deflation. But both the recent PPI and CPI data can not easily be dismissed. Something is going on -- we are entering unusual territory. Financial markets may need to grapple more seriously with these new and strange forces soon.

Hugh Whelan is an equity portfolio manager at Hartford, Conn.-based Aeltus Investment Management, which manages institutional investment accounts and acts as adviser to the Aetna Mutual Funds. His commentary on the financial markets is based upon information thought to be reliable and is not meant as investment advice. While Whelan cannot provide investment advice or recommendations, he invites you to send comments on his column to Hugh Whelan.

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