Will the US Become the Next Deflation Nation?

Since the Great Recession, the Federal Reserve has worked hard to boost the economy. Part of the Fed’s mission was to keep core inflation (the price of goods and services excluding food and energy), at a pace of two percent annually. Although there have been instances over the past six years when either energy or food prices jumped, temporarily raising the specter of inflation, throughout the financial crisis and the recovery, the central bank has been much more focused on deflation, which is defined as a drop in the price of goods and services. For those who were around during the inflationary 1970s and 1980s, deflation is an alien concept. But according to data released by the government last week, the near-60 percent plunge in oil prices pushed down consumer prices by 0.4 percent in December from the previous month, leaving the CPI just 1.6 percent above where it stood a year ago, below the 1.9 percent annual rate over the past ten years.

Although the idea of falling prices seems like a good thing, when deflation is persistent, it can put into a motion a scary, downward spiral. It starts when the economy cools, which prompts companies to reduce prices in the hopes of luring customers and maintaining sales volume. But as companies make less money, they could then cut jobs and/or wages, which could then cause consumers to spend less in order to service their fixed costs, like taxes and mortgages/rents.

The longer that deflation goes on, the higher the risk that consumers’ and businesses’ become accustomed to the situation and delay spending, hoping they will eventually be able to buy goods more cheaply and to invest more efficiently. They also become less willing to borrow.

The vicious deflationary cycle can mire an economy in a deep recession or even worse, a depression. As an example, between 1929 and 1933, US consumer prices fell by a cumulative 25 percent. More recently, Japanese consumer prices have been stuck for the past 20 years and the Euro Zone and the United Kingdom are both currently battling falling prices.

Besides the obvious harm that deflation can cause, the other problem is that central bankers have limited tools to fight it. (In contrast, when there is inflation, hiking interest rates may hurt in the short-term, but it is effective in combating higher prices.) In a deflationary environment, policy makers would likely return to bond buying (Quantitative Easing), which depending on the magnitude of price declines, may not stop the downward spiral. (FYI, there will be an excellent test case in the efficacy of QE coming up. This week, the European Central Bank is expected to unveil its version of bond buying to boost prices in the euro zone.)

Back to the US, where the big question is whether the current drop in prices is temporary or whether there is something scary brewing. Analysts at Capital Economics believe that odds are that while negative readings on headline inflation could persist at least for the first half of the year, “it is hard to see why this renewed slump in oil prices, which is developing against a backdrop of a rapidly improving real US economy, will lead to anything more than a temporary drop in inflation.” They are quick to point out that even when crude oil collapsed from a 2008 peak of $140 per barrel to $40, amid a deep recession, prices recovered and the economy avoided a prolonged bout of deflation.

That said, they also add that “Deflation may be just one recession away,” which is probably why Fed officials continue to err on the side of adding more stimulus to the economy than less and are taking a “wait and see” attitude towards increasing short-term interest rates. Currently, the consensus is for the first rate hike to occur in the third quarter of this year. But any indication of an economic slowdown, accompanied by a more substantial drop in core prices, could put the Fed on hold longer, to avoid a dangerous deflationary downward spiral.

MARKETS: Last week, the Swiss Central Bank’s decision to discontinue its 3½ practice of pegging the Swiss Franc to the Euro sent ripple effects throughout global markets. (The policy was intended to halt the rise of the Swiss currency, which made it difficult for Swiss exporters to remain competitive in the global market.) Meanwhile, the punk US Retail Sales report unnerved investors, who continue to worry about a slowdown in global growth.

• DJIA: 17,511, down 1.3% on week, down 1.8% YTD
• S&P 500: 2019, down 1.2% on week, down 1.9% YTD (still within 4% of all-time highs)
• NASDAQ: 4634, down 1.5% on week, down 1.5% YTD
• Russell 2000: 1176, down 0.8% on week, down 2.3% YTD
• 10-Year Treasury yield: 1.84% (from 1.97% a week ago)
• February Crude Oil: $48.69, up 0.7% on week (oil CAN rise!)
• February Gold: 1,276.90 $1,216.10, up 5% on week
• AAA Nat'l average price for gallon of regular Gas: $2.08 (from $3.33 a year ago)

THE WEEK AHEAD:

Mon 1/19: Markets closed in honor of MLK Day

Tues 1/20:

Baker Hughes, Coach, Haliburton, Morgan Stanley, Netflix

2014 Tax Season begins

10:00 NAHB Housing Market Index

State of the Union address

Weds 1/21:

American Express, eBay

8:30 Housing Starts

Thurs 1/22:

Southwest Air, Starbux, Verizon

European Central Bank Policy meeting

8:30 Weekly Jobless Claims

Fri 1/23:

General Electric, McDonald’s

8:30 Existing Home Sales