Fisher Investments Editorial Staff
Monetary Policy, Market Risks, US Economy

Our Erratic Queen

By, 11/28/2008

Story Highlights:

  • In October, US price levels fell month-over-month. Ever since, comparisons to the Great Depression or Japan's lost decade abound as many worry a lengthy period of deflation looms.
  • Though some of the drop is due to falling food and energy prices, and a single monthly change is no trend, we think deflation's a risk worth watching—more so than inflation at the moment.
  • Future price changes will depend on whether inflationary Fed actions overwhelm the deflationary financial panic or vice versa.
  • Luckily, it's less important to precisely quantify the risk than to recognize it and fight ferociously. And to the Fed's credit, that's exactly what it's been doing recently.

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In November, food is king and smart turkeys lobby the White House for a pardon. Of course, not noted for their intelligence, most of the birds miss the boat on that one, surrendering instead to their lot in life—the supply of coma-inducing pleasure to Americans countrywide.

But if food is king, food's price is his erratic queen. And this year prices have been front and center. Just months ago, high oil and food prices had many fretting provision of the basics, let alone anything lavish. Well, there's always something to worry about with prices—in October, US aggregate price levels fell month-over-month. Ever since, comparisons to the Great Depression or Japan's lost decade abound as many worry a lengthy period of deflation looms. And while a little inflation is a good thing, assuming income paces economic growth, a little deflation, or the general erosion of asset prices, has never been good for anyone, anywhere.

We see a few problems with claims that October's prices signal an inevitable deflationary spiral. To begin, we can assign some of the recent price drop to rapidly falling food and energy prices. Further, it's a mistake to assume a monthly change is a trend. If anything, the rapid turnaround just goes to show how difficult predicting prices in the short term is and proves measurement techniques imperfect.

But those points aside, deflation looking forward is a risk worth watching. This fall saw the first full-blown financial panic in roughly 80 years. That we'd feel deflationary effects from financial mayhem shouldn't come as a surprise. And because of the panic's severity, it's worth doing a few thought experiments to find out what's most likely to happen. (The short answer: There's some deflationary risk currently—we just don't know how much.)

First, the basics: What changes the price level? Irving Fisher's famous money demand identity's a good place to start (MV = PQ).

M = money supply (checkable deposits, dollar bills—highly liquid monetary instruments)
V = velocity of money (how many transactions said instruments fund over time)
P = the general price level (prices of stuff—this one's pretty self-explanatory)
Q = output or income (theoretically they're the same thing)

It's useful to isolate the variable we're interested in, so let's say the equation's P = MV/Q.

Counter intuitively, economic output (Q) is inversely related to price (P), when all else is held constant. That's just simple economics. Without an increase in dollars (M) or transactions (V) to chase goods, more output translates into lower prices. But because rising output has traditionally been accompanied by relatively faster growth in velocity and money supply, most folks equate faster economic growth with inflation. (It's interesting to note certain exogenous factors, like accelerating or slowing productivity coupled with bad monetary policy, have broken that trend in the past.*)

In this case however, we'll assume output is roughly constant. If anything, it could fall a little, which, MV held constant, would be inflationary. So, to find out if we'll get deflation, we need to check what's happening to the money supply and velocity. Though it's hard to quantify precisely, money supply's been rapidly increasing due to the Fed's recent actions—in the last weeks they've printed money like gangbusters. Velocity of money is even more difficult to measure directly. But it's safe in our view to assume it's fallen sharply during the panic as banks have been none too eager to lend to each other lately, let alone put capital to work in the broader economy.

Therefore, the question becomes, will inflationary Fed actions overwhelm the deflationary financial panic or vice versa? And the simple (unsatisfying) answer is: We'll know when we know. Our economic expertise is leaps and bounds ahead of what it was 80 years ago. But no matter how many opposing claims you hear, today's analysis is nowhere near an exact science, and it's a fruitless exercise to involve oneself in semantics and minutiae on the subject—the broad trend is what counts most. It's less important to precisely quantify the risk than to recognize it and fight ferociously—past panics have shown it's disastrous to do the opposite. And to the Fed's credit, that's exactly what it's been doing recently.

So, given the Fed's aggressive money printing actions, it's hard to envision a spate of truly destructive and lasting deflation, though not impossible. Perhaps more likely is a period of disinflation, where the rate of inflation slows. In either case, it's far too early to let worries of deflation give you Turkey Day indigestion.

*In his Monetary History of the US, Milton Friedman addresses the unique post-Civil War Greenback Period (1867-1879). The Greenback Period was marked by quick innovation and economic growth powered by efficiency gains. Yet it also displayed highly disruptive monetary policy. The gyrating money supply didn't pace output, hence the period was uniquely marked by fast economic growth and falling prices. A similar but opposite trend occurred in the 1970s, when a quickly growing money supply, fueled by loose monetary policy after the US abandoned the gold standard, outpaced the less productive, more slowly growing economy—hence, we saw rising prices and stagnant growth give birth to the now infamous period of "stagflation."

*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.

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