Falling prices may cause problems
By JOHN WAGGONER, SUE KIRCHHOFF and BARBARA HAGENBAUGH
USA Today
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WASHINGTON — Everything is on sale. And that's not a good thing.
Consumer prices in October fell at the fastest pace in more than 60 years, sucked down by the rapidly deteriorating economy. The prices of oil, food, cars, clothing and electronics have all plunged. Home prices continue to swoon and so do stock prices.
The nationwide fire sale might seem like a boon for consumers. But it's increasing the risk that the economy could become mired in a dangerous deflationary spiral — a widespread, sustained reduction in prices. That's something that hasn't happened here since the Great Depression.
Some economists say it's too early to tell whether deflation has set in — and many say the government's aggressive responses to the credit crunch likely will prevent sustained deflation.
Others aren't so sure. Nouriel Roubini of New York University predicts that what he calls "stag-deflation" — a recession combined with deflationary forces — will be a big concern in the coming months, here and abroad.
A deflationary spiral can have several causes, such as a glut of goods that forces manufacturers to slash prices. In the current crisis, the bursting of the housing bubble has forced home prices down, pulling down the prices of raw materials, cars and stocks.
As prices fall, consumers eventually stop spending, either because they are worried about their jobs, or because they figure they can pay less later. Companies start laying off workers because lower prices have pushed down — or eliminated — their profits. That, in turn, means even less demand.
Ultimately, higher unemployment and lower demand create a self-reinforcing cycle that further depresses profits, growth, wages and prices.
President-elect Barack Obama cited the danger of deflation last month in calling for a massive stimulus bill to put millions to work in the next two years and boost economic activity.
Already, prices are cracking nationwide:
Faith Freeman, owner of Primal Elements, a specialty soap and candle company in Huntington Beach, Calif., is planning to sell a new kind of soap early next year that will be more basic than the regular product and sell for about $24 a loaf, which you cut yourself, rather than the $35 the company usually charges.
"I'm not really thrilled that I have to do this, but I'm trying to do what I can," Freeman said.
She said her company's sales will probably be higher in November compared with a year ago because of some large orders from bigger retailers.
Costco Wholesale sold 20 percent more TVs in October than it did a year ago. But because prices were lower, the dollar amount from all TVs sold was below the year-earlier total.
Consumer spending fell 1 percent in October, the biggest decline since September 2001 and the fourth-consecutive monthly drop, the Commerce Department said.
Bargain shopper Loralisa Gainsborough, a hospice social worker in San Diego, said record-high gasoline prices earlier this year and the plummeting stock market led her to be even more careful with her money.
She has kept up the practice even though prices at the pump have fallen.
"I do a lot more comparison shopping," said Gainsborough, 36. "I know what is a good price for pretty much everything I buy."
Jeremy Melnick, a partner at Gordon's Ace Hardware, a string of six hardware stores in downtown Chicago, said people have gone from "replace to repair" and are spending less per shopping trip.
He expects to mark down Christmas-related goods earlier than usual this year and is still waiting to see how much his suppliers cut their prices, if at all, on other items.
"I haven't seen too much come down yet," he said. "It's obviously scary times for everybody."
Deflation hits investors, too. Falling prices are devastating to nearly every type of investment — except for Treasury securities.
During deflation, companies repeatedly chop prices until only the strongest are left standing.
During the 19th century, for example, when deflation was more common than inflation, railroad barons would routinely engage in price wars, slashing fares until only one or two railroads were left standing.
The victor would then buy the bankrupt companies for pennies on the dollar.
In a deflationary period, the best investment is a bond backed by a very strong issuer — say, the U.S. government or a top-quality corporate borrower.
Bonds are long-term IOUs that pay regular interest. When prices fall, each new interest payment can buy more goods and services.
Sam Stovall, chief stock strategist for Standard & Poor's, noted that one of the greatest bull markets of all time was from 1932 to 1937, when the Dow Jones industrial average soared to 192 from 42.
But stocks in the 1930s — aside from being extremely cheap, relative to earnings — were prized mainly for dividends.
Roubini, whose gloomy predictions on the U.S. and global economies have mostly come true, thinks that the collapse of the debt markets will lead to increased defaults — and that, in turn, will further feed deflation as companies frantically sell assets at any price to try to remain afloat.
"The global economy gives a good impression of having run at top speed into a brick wall," said Jeremy Grantham, chairman at Grantham Mayo Van Otterloo, an institutional money manager. "I defy anyone to find anyone who isn't cutting back. They are all deep into ways to be frugal."
Grantham thinks that "we could have something reminiscent, in some respects, to the Japanese situation" that began in the early 1990s and continued well into this decade — a long, low-grade deflationary recession.
One reason: U.S. investors in stocks and bonds may have to write off $20 trillion, he said.
"When you write off that much of your net worth," Grantham said, "it changes your world."
At least in the short term, deflation is inevitable, said Mihir Worah, portfolio manager of the Pimco Real Return fund.
"Part of it is already baked in the cake, given the fall in commodity prices," Worah said.
By mid-July, Worah expects the inflation rate to drop to -2 percent.
In the longer term, Worah is more optimistic.
"Policymakers clearly get the scope of the problem," he said.
On Tuesday, Philadelphia Federal Reserve Bank President Charles Plosser said the nation is "not close to a sustained deflation," calling recent price declines simply the mirror image of the price increases earlier in the year.
But Plosser said that just as the Fed acts to tamp down inflation, it must send a clear message that it won't let deflation take hold.
