We commonly hear clients express concerns about the risks of high inflation in the years ahead. These are certainly legitimate concerns and we have discussed that issue on several occasions. We’ve also pointed out the many ways in which client portfolios are positioned to help weather such a storm should it occur. However, it is interesting to note that we almost never hear concerns about the risk of deflation, although there are also plausible scenarios for it. Indeed, much of the federal government’s efforts with fiscal and monetary policy over the last twelve months have been aimed at fighting deflation. We would suggest that there is a tug of war underway in our economy between powerful forces of deflation and inflation. The ideal outcome is for neither force to prevail, but only time will tell.
The sources of inflationary concerns are easy to spot starting with the extraordinary monetary stimulus that the Federal Reserve has unleashed. Short term interest rates are virtually zero, the monetary base in this country has exploded, and the Fed has pumped liquidity into the economy through an alphabet soup of programs targeted at mortgages, commercial paper, bank debt, etc… Yet the latest consumer price index reflects a year over year decrease of 1.3%. And it’s not just the CPI measurement, the price deflator for gross domestic product also confirms a lack of inflation. That certainly doesn’t preclude inflation down the road, but it does signal that something important is going on now that is offsetting the inflationary impact of these policy moves. That something is deflationary pressures.
The single biggest deflationary pressure arises from the forced unwinding of the overleveraged U.S. economy. The unwinding of leverage often takes the form of defaults on debt accompanied by forced sales of assets. With an estimated one quarter of homeowners “upside down” on their mortgages, a job loss or other financial reversal is a common trigger for that scenario in the housing market. With credit availability still highly constrained, despite the Fed’s best efforts, and unemployment high and still rising, there has been steady price pressure on assets whether houses, office buildings, or consumer goods. A hole is created in the economy’s balance sheet as banks write off the value of loans, and individuals and corporations write down the value of assets. Even those who are not overleveraged feel the effects of the wealth destruction from the lower asset prices which in turn reduces spending power in the overall economy. Given the high leverage our economy has been built over the last fifty years, even a modest unwinding will take a number of years. So these deflationary pressures are likely to persist for some time.
Other deflationary pressures arise from the slack in the world’s manufacturing and employment bases. When plants are operating at levels below capacity, the inclination is to cut prices to stimulate demand so as to better cover fixed costs. That price cutting inclination is currently very high because utilization is very low. Capacity utilization in the U.S. economy now stands at 70.5%, up slightly from its nadir of 68.3% in June which was the lowest reading since this data series began in 1967. There is an unusually large amount of slack on the labor side with unemployment approaching 10% in this country. This largely prohibits price pressures in that arena without even taking into account the large pool of labor availability in the developing world.
While we’ve highlighted the powerful deflationary forces in the economy, we’re not arguing that deflation is the most likely course for prices over the next several years. Rather, we’re suggesting that anyone focusing on the obvious inflation risks in the economy needs to balance that view with the recognition that there are less obvious countervailing pressures present that most of us haven’t seen in our lifetime.