Why Deflation Will Persist Longer Than You Think

One of the most hotly watched economic indicators is the Consumer Price Index (CPI), as it is a proxy for inflation in the US economy. This is an extremely important number, especially given the state of the US consumer and its impacts on yields in the fixed income markets. At the beginning of  the year, with sky rocketing commodity prices and increasing food prices we were looking at a period of extreme inflation during the beginning of a downturn, of which we knew very little about. Ever since the collapse in commodity prices and devaluation of every asset class known to man, we have seen a major change from what this indicator has been telling us. It paints a picture of a time of what could be one of the most deflationary environments ever seen in our economy, as the past 3 months have seen negative CPI prints, signaling extreme deflation.

With the Fed undertaking a policy of quantitative easing to stimulate the US economy and the credit markets, many people claim that we will be seeing a very inflationary environment in the near future.  The question is, how long can and will deflation persist for, and what are some of the things that will drive inflation or deflation going forward? It is my opinion that we will continue to be in this extremely deflationary environment longer than people think, but let’s see why.

1. Unemployment/Lack of Consumer Spending - The current state of employment in the US economy and the prospect of it going forward paint a very deflationary picture. With the unemployment rate ticking up to 7.6% and over 3.6 million people having lost their jobs in the past 12 months, with more and more job cuts coming from companies every day, the chances of the US consumer making up over 70% of GDP like they have in the past is extremely unlikely (they were 63% in the latest report). This is extremely important for inflation/deflation forecasters to keep in mind. While many pundits love to scream that the quantitative easing policies taken by the Fed to stimulate the economy are extremely inflationary, one has to keep in mind that it’s not only the supply of money that matters, but the velocity of money (the rate at which it is spent) too, which has collapsed. Until we see the velocity of money pick up, which stimulates the multiplier effect, we will continue to be in an extremely deflationary environment.
2. Excess Capacity - As of now there is almost $1 trillion in excess capacity in the economy (aggregate supply is $1 trillion greater than aggregate demand). This is an extremely deflationary condition and should persist, unless the consumers can somehow snatch up this $1 trillion of capacity in a short amount of time: I would not count on that.
3. High Inventories - While the latest GDP report came in better than expected at -3.8%, the internals of the report were absolutely terrible. Most of the difference between the real number and consensus was due to much higher inventories (consensus was calling for a $100 billion decrease in inventory, but there was a $6.2 billion increase). This could mean two things: companies are stockpiling inventory in hopes of selling it in the coming quarter (yeah right) or they just can not get product off the shelves (this one sounds right). This has caused many economists to essentially flip-flop their 4Q08 and 1Q09 GDP predictions, as some are calling for nearly a -6% GDP decline in 1Q09. This huge inventory buildup is extremely deflationary, as companies likely will not be able to get product off shelves, especially given the state of the current US consumer, causing an even bigger build up of inventories, causing prices to come down and further deflation.
4. Increase in the Savings Rate - Since September the savings rate has tripled (from 1.2% to 3.6%), which in and of itself is extremely deflationary. Given the fact that almost every consumer in the US is de-leveraging their balance sheet, paying down debt and increasing savings with any type of added wealth, the prospects of this money actually hitting the economy, GDP wise, is extremely low, and would not help increase the velocity of money, further strengthening deflation. This is one of the problems with the stimulus plan and its proposed $275 billion tax cut. It increases the wealth of the consumer, not the income. Consumers will be more inclined to save added wealth, as opposed to an expected increase in future income, which would help stimulate the economy better, by inducing expenditures on the consumers part.
5. Housing Prices - Housing prices have only come down approximately 25% and the level most economists are looking for in terms of reaching equilibrium is for housing prices to fall 40% from their peak. Given the strong possibility that housing prices will continue to decline,  by up to 15%, should help drive deflation going forward. So unless you think the housing market has bottomed, with supply still at 9.2 months (normal market conditions are at 6 months), then the likely decline in housing prices is very deflationary.
6. Private Sector Debt/Income - The ratio of private sector debt to income is still at all time high levels of 140%! That is how highly levered this economy is and shows the depth to which the average consumer took on levels of debt they could not afford. In normal market conditions, this number is normally at 80%. Economists suggest that this could cause the consumers to unwind nearly $6 trillion of money in the system, as part of the de-leveraging process. If the need to get rid of trillions of dollars in consumer spending money is not deflationary, then I do not know what is!

As you can see there are many deflationary aspects of the economy, that are not even close to working their way through the system over the next 3-6 months. This is going to be the toughest part of the recession as nothing can really speed up the de-leveraging process that banks and consumers are going through. The only cure is time and for the time being, until some of the above indicators improve, we should continue to see deflation persist in the US economy, probably for much longer than people think.

Disclosure: None

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