Deflation Fear Haunts Market

Copyright © 2008, Greenwich Financial Management Inc., a registered investment advisor.

The main U.S. consumer inflation index registered a sharp drop in October. The Consumer Price Index-Urban Area (CPI-U) fell 1%, the largest single month decline in the 61 years the survey has been taken. The CPI-U survey depicts the cost of a representative basket of goods and services in a variety of U.S. urban markets.

The CPI decline fanned fears of deflation and led to a further rout in the main stock indexes. Although most central banks view their main mission as fighting excessive inflation, it is accepted that a moderate rate of inflation, such as 1%-3%, is ideal. Deflation, a falling in absolute price levels for a broad variety of goods and services, is much feared by economists and central bankers as a corrosive and insidious problem.

The greatest percentage price decreases occurred in the volatile food and energy components of the CPI-U, particularly energy. The core index, excluding food and energy, fell only 0.1%. Thus, the market may have over-reacted to the CPI news, since the recent fall in energy prices was already well-known. Nevertheless, the easing of price levels has been accompanied by further indicators of weakness in the problematic real estate sector, including a drop in new housing starts of 4.5% in October, high inventories of unsold homes, rising rates of mortgage delinquency, and signs of trouble in commercial leasing. Weak demand conditions have started to afflict other sectors as well, including retail, transportation and technology.

Why is deflation so feared? One reason is that when prices fall, traditional methods of stimulating economies by lowering interest rates may not work, even when nominal interest rates approach or reach 0%. An example may illustrate how this works. Suppose you are a purchasing agent who will need goods in one year, and suppose you can borrow for one year at 0% but you expect the price of what you can purchase in one year to fall by 10%. You would save 10% by waiting to buy, instead of purchasing now with borrowed funds and stockpiling the item.

An often cited recent example of a prolonged deflationary spiral is Japan after the collapse of the so-called “bubble economy,” beginning in late 1989. Japan found that low interest rate medicine alone was not simulative enough. Indeed, our own Fed is running out of room to drop rates. The Target Fed Funds Rate is currently just 1%, having already by dropped by a full ½% on October 29th. Still, expect the Fed to announce a further cut at its December meeting, or perhaps earlier.

Suppose deflation becomes a stubborn problem for the national and international economy. What are the investment implications? First, borrowers will have a harder time repaying loans, as the real rate of interest (after considering inflation) is increasing. Thus, banks in theory benefit, if they have not hedged out their rate risks. However, depending on the magnitude and persistence of deflation, the banks would face a rising tide of delinquencies and defaults in an already dicey environment. Second, portfolios of bonds should do better, as deflation implies low interest rates. Third, stocks may not do well, but among sectors, consumer staples should do better than discretionary purchases. People still need to buy groceries and go the drug store, but they may well skip purchasing the 50 inch flat screen display. Fourth, commodities and precious metals in general will perform poorly. Fifth, real estate investments of all kinds would suffer.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.