Don’t Bank on Deflation

Deflation has resurfaced as a hot investor concern lately. Headlines warn that deflation looms, fret the Federal Reserve has no tools to deal with it, and offer "tips" on how best to prepare. Before hoarding cash under the mattress, let's put today's concerns in perspective.

First, what exactly is deflation? Deflation is persistently falling prices on a broad scale triggered by a declining amount of money in circulation, vast increases in the quantity of goods money chases, or both. Of course, some specific items regularly deflate in price—just think what a 50" LCD TV cost only five years ago. But this typical occurrence is usually offset by inflation elsewhere. That kind of deflation we don't fear, and actually quite like. Rather, today's fear is of much broader deflation derailing economic recovery. Theoretically in a "deflationary spiral" consumers will delay spending, preferring to wait for lower prices ahead. Thus, slowing spending slows economic activity generally. Fine theory, but occurrences are extremely rare—protracted deflation has occurred just a few times in modern history.

The last protracted US deflationary period was in the 1930s. From 1929 to 1933, the money supply shrank fully a third. It didn't start so badly. Under George Harrison (New York Fed Governor, not Beatles' guitarist), the Fed actually responded admirably with lower interest rates and aggressive open market operations—after the crash the market rallied hard into 1930. But subsequently, the Fed didn't lower rates or support banks—it tightened, its balance sheet dwindled, and successive bank panics drained dollars from the economy. Despite over 1300 bank failures in 1929 and 1930 combined (over 8,000 failed from 1929-1933), the Fed did little to add to liquidity.[i] As prices plummeted, businesses and individuals hoarded dollars likely to increase in value. Given monetary policy errors, it's no wonder spending and lending slowed so dramatically. Later, the 1937-1938 recession showed similar features (but not as long-lasting), again tied to money supply and Fed error.

The Depression aside, examples of prolonged deflation are clustered in the Fed's infancy (when monetary policy was new thinking in the US) or before the Fed. Economic data from the mid to late 19^th century is murky at best, but the preponderance of evidence indicates deflation was a much more regular occurrence then. For one, the Industrial Revolution increased productivity and manufacturing capacity dramatically—meaning the money stock chased a vastly larger pool of cheaper goods—a deflationary pressure, but not entirely negative. (In fact, society benefited greatly overall from the vast productivity gains.) Add that to the era's lack of a central bank, flip-flopping over the gold standard, a fickle money supply tied more often to mining discoveries than economic growth—and deflationary drivers become clear.

That was then. But what about more recent deflation fears? In 2008, deflation concerns had some merit. After Lehman Brothers failed, banks were unsure of peer health (due to FAS 157 [fair value accounting] and confusing government responses) and largely ceased interbank lending. This then resulted in less lending to consumers and businesses slowing money movement—triggering Consumer Price Index (CPI) declines in late 2008 (most notably in October, November, and December).

But unlike the Great Depression, central banks appeared to have learned their lesson and met slowing velocity with a wall of liquidity. Using actions like quantitative easing, cutting short-term rates to zero, and many more, global central banks attacked deflation directly in 2008 and 2009—and CPI rose soon thereafter. So while headlines today frequently claim central banks lack tools to fight deflation, the exact opposite is true—and we just saw that. Due to the combined actions of central banks around the world, 2008's price drops weren't a prolonged spiral. It's true Japan has used similar tools to less convincingly battle an extended bout of deflation beginning in the early 1990s. But Japan dragged its feet—never really committing to the fight until deflation was thoroughly entrenched. That's in stark contrast to the Fed and other central banks' extreme alacrity getting rates to zero and implementing quantitative easing.

Still fears persist into 2010. Today's deflationists look primarily at economic slack (spare capacity and unemployment) or antiquated statistics like US M3 (which the Federal Reserve doesn't use) showing money supply is contracting sharply. When dipping energy prices drove April, May, and June CPI reports to three successive monthly declines (-0.1%, -0.2%, and -0.1% respectively), headlines screamed. But it's early in economic recovery to expect all slack to be worked off—some of which is explained by big productivity gains. And more accurate M2 money supply is still growing—up 2.9% in 2010 (through July). In fact, core CPI (stripping out volatile energy and food prices), increased modestly throughout the April-June period.

Most importantly,we have neither persistently falling prices nor falling spending—the two telltale signs of problematic deflation. In July's CPI reports, prices rose modestly—and less volatile year-over-year CPI increased 1.2% (core CPI rose 0.9%). (In fact, CPI hasn't fallen year-over-year since 2009 and core CPI hasn't declined year-over-year at any point in recent history.) US consumer spending has also risen in 2010—at annualized rates of 1.9% in Q1 and 2.0% in Q2.[ii] Business spending rose even more sharply in the same period. Looking forward, the Fed has explicitly stated multiple times it plans to maintain exceptionally accommodative policy. Translation? Don't expect a big contraction in money supply soon.

What's more, global investors need to look around the world. Today the UK, eurozone, India, Brazil, China, Australia, Canada, and more all have rising prices, not falling. Some countries may have isolated cases of deflation—but these are generally driven by very country-specific situations. Today, ample money supply globally is a modest inflationary pressure, which is reflected in prices.

Historically, prolonged deflation is generally brought by big supply-side changes—either due to monetary error or landmark technological advance. The Fed clearly isn't perfect, but it has recently demonstrated lessons learned in avoiding deflationary spirals. In addressing questions raised, Fed Chairman Ben Bernanke recently said, "Deflation is not a significant risk for the United States at this time." While some skepticism of government is healthy, positioning a portfolio for a deflationary environment is to disregard powerful tools recently used (and still available) and speculate on monetary policy errors not yet made.