I was having a conversation yesterday with a good buddy of mine who doesn’t understand the big fuss about deflation. In his mind, what’s not to like?
Rent on his apartment is significantly less now than during the pre-financial crisis days and he boasts about walking around the mall and finding everything on sale for 40%, 50% or even 60% at any given time. So when he pulled out the print edition of the Journal yesterday and saw the headline “Big Investors Fear Deflation,” he was puzzled.
Yes, for people who still have decent-paying jobs and some dough in the bank, and not a lot of fixed debt, a little deflation doesn’t hurt. But in a broader economic sense, the prospect of deflation is downright frightening.
The Journal’s deflation piece, which Paul referenced yesterday, explains how some big-name investors, including Bill Gross, Jeremy Grantham, David Tepper and Alan Fournier are changing their investment strategies in light of deflationary fears. Even St. Louis Fed President James Bullard last week publicly warned about deflation and the potential of a Japanese-like lost decade, or period of slow growth.
Why all the fuss about deflation? WSJ explains in a nut shell:
Deflation is seen as pernicious and hard to address once it sets in. Falling prices can make businesses and consumers reluctant to spend and invest, hurting profits and crippling the economy. It can be caused by a drop in the money supply and credit, declining spending and high unemployment, all of which can encourage companies to cut prices.
That’s tough to grasp, especially since a deflationary environment doesn’t seem so bad on the surface; who doesn’t love cheaper prices on, well, everything? But Paul Krugman further explains the dangers of deflation and why it’s such a bad thing.
“When people expect falling prices, they become less willing to spend, and in particular less willing to borrow,” he says. “When that happens, the economy may stay depressed because people expect deflation, and deflation may continue because the economy remains depressed. That’s the deflationary trap we keep worrying about.”
Another interesting point is as we enter the dog days of summer, the perpetual inflation/deflation discussion is heating up, but it has a different tone than last year’s debate, FT’s Alphaville points out.
“The summer of 2009 was characterized by one almighty debate between those expecting Japan-style deflation, those who forecast inflation — and those who thought monetary conditions would be ‘just right,’” Alphaville says. “Fast forward a year and we’re having the same argument, though the emphasis has shifted dramatically. The deflationistas appear to have suddenly grabbed the upper hand.”
But with interest rates near zero, what can the Fed do? Weakening economic data have prompted rumblings that the Fed needs to do something, anything, to jump start the economy. The Journal’s top story today is about the Fed “mulling” additional measures to support the marketplace, such as plowing cash from its maturing debt back into the Treasury market.
University of Oregon economics professor Tim Duy says there is increasing chatter that additional quantitative easing measures will be put in place sooner than later. There’s only one big problem with this theory: Ben Bernanke doesn’t seem overly concerned with the economic outlook and isn’t portraying a sense of urgency. In fact, the Fed chairman said rising wages will ultimately spur household spending in the next few quarters.
But we found this morning that personal income in June was flat as private wages and salaries fell, statistics that have to keep Bernanke up at night, even if he isn’t willing to publicly admit it.
Can we expect big policy changes in the future? According to Duy, the answer is obvious.
“The chatter is becoming almost undeniable,” Duy says. “Someone is sourcing the press to believe that a policy change is imminent. And Fedspeak aside, that source cannot be ignored.”
So, for my friend and I, deflation looks pretty good. And why wouldn’t it? We’re just a couple of dudes in our mid-20′s who don’t have families, mortgages or car loans. We aren’t in credit card debt and we have jobs (knock on wood).
But let’s check back in a year and see how things look if this deflationary environment truly spirals out of control.