Deflation in the air?

    I first talked about the potential for deflation in 1998, in connection with my economic take on Y2K, and its potential for disruption of the markets.  As time goes on, more and more of the economic ramifications I predicted 5 years ago have indeed happened.  Large stock market decline, bonds performing strongly,  and gold being something to avoid for several years (gold finally bottomed in late 2000).  Finally deflation may be here, too.

    As you may remember from the supply-and-demand part of Econ 101, inflation is caused by too many dollars chasing too few goods, bidding up the price of the goods.  Deflation is the opposite, too many goods chasing too few dollars and the price of the goods goes down.  According to the Federal Reserve, the PPI Index, which measures prices at the producer level, fell last year for the first time in the 31 years that this data has been kept.  If not for rising oil prices, I’d guess that the Consumer Price Index, which measures inflation, would have been negative, too.

    Falling prices are welcomed by most consumers but they are devastating to businesses as falling prices cut into profits.  Falling profits mean more layoffs and fewer business expenditures, making fewer dollars available to be spent and the cycle accelerates.  Deflation can be vicious to business.  Just look at Japan’s 12 year battle with deflation to see what it can do.  (Japan has a host of other problem’s too, like mass denial, but deflation is a real problem over there.)

    Ironically, the productivity of US business is part of the problem.  As more goods are produced by fewer workers the imbalance between goods produced and dollars willing to be spent becomes more pronounced.  Now as productivity gains are announced in economic reports, instead of proudly welcoming the fact like one would expect (Being productive is good, right?), now I silently groan.  How many times have I said this is a crazy business?  Many things seem to be backwards from what one would expect.  That’s why being a successful investor is very difficult.

    An interesting side note:  The business press seems befuddled about the large number of gift certificates that were purchased for the holidays. Why the confusion?  Folks on main street are getting wise to the deflation game. As one person put it, "I gave everyone gift certificates this year. My teenagers can purchase exactly what they want at 50% off during the after-holiday sales." It seems the consumer is already adjusting to deflation.