Recently we have heard a lot about the potential for economic deflation. This blog post will be about defining what deflation really is and taking a look at the big picture to evaluate whether it is a true threat or not. More after the jump...
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Deflation: What It Is
It is actually pretty simple. It is when prices generally decline in the overall economy. It hasn't happened too often. During the period from about 1922-1938, during the Great Depression, deflation is what helped make it "Great". When prices decline as a result of a lack of demand, workers are laid off in order to lower costs. This spirals out of control to the point where economic activity slows dramatically. When this happens, since it is a cycle, wages typically fall and the Federal Reserve Board really runs out of ammo to stimulate the economy. They can lower interest rates as much as they want but they can't go below zero. Additionally, everyone circles the wagons and resists raising capital because it probably wouldn't help their bottom line anyway.
How Close Are We to This?
Over the last 12 months our consumer price index, a proxy for overall inflation, has risen by 1.1%. Take out food and energy and it only rose 0.7%. That's pretty low. As you know, that Fed is trying to stimulate our economy through lower interest rates and supplying banks with as much money as they need to lend. Banks, for good reason, are hesitant to lend loosely from fear of getting hammered by the regulators reducing their capital ratios with non-performing loans.
There are several factors that could have significance in propelling us into a deflationary spiral if they were to simultaneously go the wrong way: oil prices, food prices, the dollar, and the unemployment rate. I'm going to discuss in some detail those I think are likely the most important: the dollar and the unemployment rate.
We have run a current account trade deficit as long as I can remember. In 2010 the US current account trade deficit rose to about 3.5% of gross domestic product from about 2.5% a year before +40%. Clearly, we are not competitive with the rest of the world in several key areas. We are importing the majority of our oil which we use to drive our not-so-competitive economy. Combinations like this do not work in our favor. Occasionally, the flight to quality increases the value of our dollar, but long-term our dollar value trend is down since about 2002. We are more stable now, but we are not gaining much ground. A lower dollar makes our goods less expensive for overseas buyers, but it still reflects the fact that we are buying more than we are selling. Please know that there are many more factors affecting the dollar’s value. The price reflects their combination effect, though.
It is estimated that gross domestic product growth of somewhere between 4% and 5% might decrease our unemployment rate by about 1% per year. Currently we are sputtering along at less than 4% (unusually low for this phase of a recovery). Our growth rate could improve dramatically because economic recoveries typically gain steam at an increasing rate for while. However, there still appears to be a bit of a headwind in the face of corporate America
Real Estate
Real estate value underlies many of these issues. In many areas of the US Japan Japan
The federal reserve board statement of January 26, 2011 weighed in on our current situation with this quote: "The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the federal funds rate for an extended period."
Going Forward
The Fed’s actions tell me that we are not out of the woods. If we were, they would be targeting rates at a more normal level. Economic recoveries can produce surprisingly fast stock market recoveries. They can also produce surprisingly big declines. If investors are inclined to gamble before many of the pieces are in place, this is probably the time. Regarding their serious money, however, until sound reasons for a robust economic recovery appear they should not be lulled to sleep.
In a blog in the near future I expect to discuss stock market gains against the backdrop of our very slow economy.
Take Care,
Chris
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results.
