Inflation versus Deflation
Kurt Brouwer November 18th, 2008
In those halcyon days before Hank Paulson, TARP, subprime and credit default swap became household words, there was widespread concern about inflation. Though it seems like a distant memory, it was only five or six months ago that inflation was soaring along with oil, food and other commodities. Oil hit $146 per barrel and gasoline was north of $4 a gallon.
This is an interesting chart in that it illustrates the inflation-adjusted price for a gallon of since 1980.
Source: Carpe Diem
Earlier this year, the news was full of stories about the inevitable trend towards higher and higher gas prices. Yet now, gasoline prices are falling and from this chart we can see that we are paying the same cost for gas that we were paying 28 years, once inflation has been factored in. Actually, our gas bills are probably lower because cars generally have better mileage today than they did back then.
With falling prices for energy and other commodities, inflation is no longer as visible a concern as it was earlier this year. In fact, the pricing of TIPs (Treasury Inflation Protection) bonds reflects a most benign view of future inflation — slim to none. What a difference a few months makes (see Inflation Falls In August). But, with shares in the stock market plummeting, real estate prices falling, bond prices down along with commodities, another specter has arisen — deflation.
Inflation means that we are experiencing a general increase in the price of goods we buy. Deflation is the opposite, that is, a general decline in the prices of the goods we buy. Inflation is very common in most developed countries, but deflation is rare. The last time we had protracted deflation was in the Great Depression of the 1930s.
We have often seen asset deflation in a particular market such as stocks from 2000- 2002. But, we very seldom see deflation across the range of most assets — stocks, bonds, real estate, commodities and so on. However, that is exactly we have in front of us now. And, that’s why, this financial panic and economic downturn is frequently linked to the Great Depression because we have seen wholesale asset deflation over the past year or so just as we did back then.
Recently, we have also begun to see declines in the cost of living. That is, in August and September, the Consumer Price Index (CPI) actually went down slightly. As a sign of things to come, we are also seeing falling wholesale prices due to declining demand. With falling wholesale prices, we can infer that we will see declining inflation in the months to come. This piece from AP gives some details [emphasis added]:
October Wholesale Prices Plunge Record 2.8 Percent (Real Clear Markets / Associated Press, November 18, 2008, Martin Crutsinger)
…The Labor Department reported Tuesday that wholesale prices dropped by 2.8 percent in October, the biggest one-month decline on records that go back more than 60 years. The previous record holder was a 1.6 percent fall in October 2001, the month after the terrorist attacks.
The overall decline in the department’s Producer Price Index was bigger than the 1.8 percent drop analysts had expected. However, core inflation, which excludes energy and food, was not as well-behaved, rising by a bigger-than-expected 0.4 percent.
The 0.4 percent rise in core inflation did not alter the view that plunging energy prices and a sharply slowing economy were combining to slash inflation pressures.
Analysts said much of the jump in core prices reflected the lingering impact of the huge rise in energy costs earlier in the year and should retreat in coming months as those costs continue to fall.
Ian Shepherdson, chief U.S. economist at High Frequency Economics, predicted that core wholesale prices would retreat significantly in coming months.
The 2.8 percent overall decrease marked the third straight month that wholesale prices have fallen.
What we are witnessing is the stark beauty of markets behaving in ways that make economic sense. If demand is falling, those who make and sell goods reduce prices. At some point, those lower prices become tempting and businesses and consumers begin buying again. In other words, deflation is not all bad. Computer prices have been falling for many years and consumers have really benefited. We have seen sharp declines in the cost of telephone calls and cell phones and many other electronic goods. Now, the slumping economy has weakened demand enough that, at least, most goods and services are under some pricing pressure. As a result, overall inflation has fallen slightly.
Keeping prices stable is a primary function of the Federal Reserve. Generally, that means holding the rate of inflation in the Fed’s preferred range of 1-2% per year. That moderate rate of inflation seems to be what the Fed believes will work best given the Fed’s other mission, which is to also seek full employment. Earlier this year, the rate of inflation cranked up quite a bit higher than the Fed would have liked and that presented a series of problems.
As awareness of higher inflation increased, the Fed was suddenly faced with a different and starkly different set of problems caused by falling asset prices. Home prices have been declining since late 2006 or early 2007, but the decline accelerated. Falling real estate prices exacerbated problems mortgage securities and the impact of cratering prices for mortgages filtered through the financial markets and stocks and bonds began losing value. Finally, over the summer, energy prices ran out of steam and began falling.
The AP piece continues:
The PPI report showed that energy prices dropped by 12.8 percent in October, the biggest one-month fall since a 14 percent decline in July 1986.
All types of energy showed big declines with gasoline falling by a record 24.9 percent, surpassing the old mark of a 22.1 percent drop in March 1986.
Home heating oil prices were down 9.6 percent, natural gas intended for home uses fell by 5.9 percent, and liquefied petroleum gas dropped by 27.6 percent, the biggest decline in more than three decades.
Light, sweet crude for December delivery rose slightly Tuesday morning after falling $2.09 to settle at $54.95 a barrel Monday, the lowest since January 2007. Prices have fallen more than 60 percent since reaching a record above $147 a barrel in mid-July.
Food costs edged down 0.2 percent last month, as declines in the price of milk and meats offset a big jump in vegetable prices.
Update: As noted above, the trend for consumer prices is lower and lower. This piece from the Associated Press makes the point [emphasis added]:
Consumer prices plunged by the largest amount in the past 61 years in October as gasoline pump prices dropped by a record amount.
The Labor Department said Wednesday that consumer prices fell by 1 percent last month, the biggest one-month decline on records that go back to February 1947. The drop was twice as large as the 0.5 percent decline analysts expected.
…The big drop in inflation reflected not only a huge fall in gasoline and other energy costs, but widespread declines in other areas. Core consumer prices, which exclude food and energy, fell by 0.1 percent last month, the first drop in core prices in more than a quarter-century.
There were price declines for clothing, new and used cars, and airline fares. Analysts predicted further declines in the months ahead as retailers struggle to attract consumers who are being battered by rising unemployment and the weak economy.
…The big retreat in consumer prices represented a remarkable turnaround from just a few months ago when a relentless surge in energy prices raised concerns that inflation could get out of control…
Falling prices for consumer goods mean that people have a little more money in their pockets than they would have had if prices stayed high. For example, I have seen several estimates of the annual savings we obtain from each decrease in gas prices of one penny. As I understand it, each one penny reduction in gas prices saves Americans well over $1 billion per year.
As the average price is down by about $2 from the high point of $4.12 or more, I estimate that the annual savings will be somewhere between $200 and $300 billion.
Falling consumer prices are a good thing, but there are concerns about generalized falling prices, i.e. deflation. A generalized state of deflation is viewed with fear and loathing by most economists because it can be very disruptive. As a result, the Fed is working hard to inject cash and capital into the system to help stem the losses at financial institutions. The net result of all these attempts is to inject vast amounts of liquidity into the financial system, which generally means — you guessed it — higher inflation down the road.
For now, consumer prices are falling, but the seeds of inflation are being planted in an effort to avert deflation.
- Economy , Geopolitics , Investing , Money , Mutual Funds , Personal Finance , inflation
- Comments(9)
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Hi Kurt,
I’m emailing you in regards to an email I sent to you last month about a partnership, have you had a chance to think about it?
If you have any questions or would more information, please advise me and we can go from there.
Kind Regards,
Andrew Knight
Kurt,
I always enjoy your posts, this is another good one.
Deflation scares me some. We are in the midst of a retail crisis — Americans just aren’t shopping like they used to (obvious reasons aside). Yet, yesterday we saw the PPI drop, and today the CPI. If you follow the trends, which I know you do, CPI should continue to dip in the coming months as it catches up with the last three months of decline reported in the PPI (natural lag between producer and consumer pricing).
Back to my main point, deflation scares me a little. What if the current home-buying philosophy — since prices are steadily dropping, just wait for them to fall further before you buy — makes its way to retail shopping, perhaps it already has. Consumers will wait on the sideline to purchase that new laptop or TV until the price falls a little further, then maybe a little further.
While I agree the easing of inflation is very welcome news, deflation could become a reality if we’re not careful. Lower food and energy prices have allowed consumers to have a portion of their earnings available to spend on other items they hadn’t had before. They just hope they do.
Another great post,
Tim Manni
Thanks Tim. I think you captured the downside of deflation very well. As prices fall, potential buyers may hold off on purchases in anticipation of further price declines. This is the opposite of an inflationary environment in which people often buy today in anticipation of higher prices tomorrow.
Another potential issue is that those who have borrowed money would have to repay it with more expensive dollars in the future. That is, if prices fell 5% by January 1, 2009, then a dollar would be worth more in January then it is worth today, in terms of purchasing power. Therefore, repaying debt costs more. Conversely, in an inflationary environment, repaying a fixed debt incurred today generally entails doing so with dollars that are worth less (not worthless) in the future.
Yes, the current condition is deflation - but that will probably only last until assets (houses, cars, stuff) has been liquidated. Then, we will see massive inflation.
The most dangerous variable is if foreign nations stop lending the US money (Japan, China), because they need the money to save there own economies.
When this happens, the dollar will sink in value and America will suffer from a major spike in inflation, while the rest of the world will see an decrease in prices of good related to their currencies.
We need large ($700 billion plus) tax rebates for the specific purpose of cash flow for the private economy to replace debt with equity on the private balance sheet. This will enhance consumer confidence and is a back door way of supporting the financial system by reducing bank leverage. When the value of currency is rising relative to other assets, It is just as important to print money for price stability as it is to stop printing money for inflation
Consider World War II from an economic viewpoint. It was a huge public works operation financed by unprecedented deficit spending. It commandeered the productive capacity of this country and then destroyed this production in the battlefield. Why didn’t this bankrupt the country? Theoretically, an operation like that should have bankrupted the country like a “closed system” business operation would have been bankrupted. (Fortunately, free-market capitalism at the macroeconomic level is “open system”)
One can only imagine the derision and criticism had anyone of stature, in the 30s, proposed such a program to end the depression economy. But there’s no denying that World War II deficit spending did do it. Until one has a theoretical framework that can satisfactorily explain why World War II, not only did not bankrupt the country, but was the key factor in economic recovery — all one can do is bewail the problem without offering any solutions that will work.
“Open system” perspective: http://economics102.blogspot.com/
You did not make the case for the benefits of deflation.
Several real scares were overlooked: As the real price of goods, services, and ultimately, incomes fall, the real cost for repayment of debt will start to rise, making it ever more difficult for debtors to pay off their obligations. This will lead to increased debt resignation, where borrowers decide to give up the struggle of maintaining debt service, and the number of debtors who throw in the towel and declare bankruptcy will increase drastically.
These factors will cause the economy to continue to shrinking, and real personal suffering will become evident.
I am a bankruptcy lawyer, and I have to strongly disagree with your perspective on deflation.
Falling prices are a good thing if the reduction is brought about by advances in productivity. Prices that drop due to deflation will not mean that consumers have more money to spend. They will have less money, because real incomes are also falling. Even if the average worker suffers no salary reduction, the numbers of the unemployed are rising. On an enlarged scale, the economy is suffering a drop in real earings, and that is where the economic crisis lies.
Deflation is scary for individuals and businesses who have abused credit. It is also scary for out-of-control government spending. It is terrifying to bureaucratic leeches who might actually have to work for a living. Trust me, friends, deflation is God’s way of saying that credit excesses will be dealt with. Too many people have been living in a fantasy world created by the Federal Reserve system. We can’t keep prospering by selling insurance and real estate to one another. We have to pursue excellence in creating real products that we can sell on the world market. We must export value added industrial goods that others want. That means competition. That means we can’t keep rolling out idiots in our schools who major in stuff like “oppression studies” and the like. We either take this as a cold slap in the face or we continue to diminish. I say, bring on the deflation and let’s get it over with.
Kurt,
Tim seems to attribute deflation to people not spending their money now but waiting until prices fall.This is not deflation it is a price adjustment process to bring supply and demand back in balance. You own a computer don’t you, I have bought 6 so far each one did more and cost less.What are the odds that the next one I buy will do more cost less, that didn’t stop me from buying the previous 6.It is not an illustration of deflation either.
Deflation is an increase in the value of a currency which causes prices to adjust to reflect the greater value of the unit of account , in the case of the US it’s the dollar.
Many thanks for all the thoughtful comments. I’m not exactly recommending the benefits of deflation, just pointing out that we are experiencing deflation in a broad array of assets — real estate, stocks, bonds, gold, oil.
Deflation is scary for leveraged entities, whether they be individuals or businesses or nations. Owing a debt based on a falling asset value is uncomfortable. Anyone who bought a car should be used to that, but when it happens globally, it’s tough.
As I pointed out in the post, deflation can be good in some cases. ‘…In other words, deflation is not all bad. Computer prices have been falling for many years and consumers have really benefited. We have seen sharp declines in the cost of telephone calls and cell phones and many other electronic goods. Now, the slumping economy has weakened demand enough that, at least, most goods and services are under some pricing pressure.
The first type of deflation is pretty beneficial and it stems from pricing pressure on companies such that they figure out how to add more value for a lower price. And, that means they have to be more productive. However, deflation from slumping demand is less beneficial because the impact of that ripples through the economy and causes job losses.
In the real estate market, buyers are simply waiting because they wonder if prices will fall further. We also see the same in stocks and bonds. There is about $4 trillion in money market funds earning very low returns, but because of uncertainty, investors are staying put.