By Laura Mandaro
SAN FRANCISCO (Dow Jones) -- Bargain shoppers, beware. The last
time a major economy experienced repeat price cuts across a broad
range of consumer goods, the stock market lost 80% of its value and
unemployment hit its highest level since World War II.
That was the outcome of Japan's bruising bout with deflation,
which crept into the world's second-largest economy in the
mid-1990s and didn't let up until 2006.
As unappetizing as it sounds, a U.S. version of Japan's
so-called lost decade could be in the works.
A two-year slump in house prices has spread into a broad
recession, sapping demand and driving down prices of manufactured
items like cars and clothes as well as commodities like gasoline
and milk. The consumer price index, the most widely watched
barometer of inflation, will likely go negative this year.
Deflation isn't here yet, says Sherry Cooper, chief economist
for BMO Capital Markets, "but it's the closest we've come since the
Great Depression."
"Housing prices are falling, commodity prices are falling, so
are lots of goods and services -- that sounds scary to me," she
said.
And some of the projections are enough to keep folks up at
night. U.S. consumer inflation is expected to fall 2% this year,
according to RGE Monitor, the economic research firm lead by New
York University's Nouriel Roubini. The group also predicts
deflation could persist until 2010 while the country flirts with "a
near depression," says Christian Menegatti, an RGE analyst.
David Rosenberg, the notoriously bearish North American
economist at Bank of America Securities-Merrill Lynch, sees
deflation as the "primary risk" to investments in the near future.
He expects the CPI to post year-over-year drops every quarter this
year.
"It is truly difficult to believe inflation is going to be
revived in the intermediate term," as Rosenberg put it in a report
last month.
Alternate case: prices rise
Some forecasters are more optimistic, predicting that
Washington's pending economic stimulus package and the trillions of
dollars the Federal Reserve and Treasury Department are injecting
into the banking system will lower borrowing costs, stimulate
purchases and keep prices rising.
"I think we can probably avoid it," said Nariman Behravesh,
chief economist for IHS Global Insight. That's "mostly because of
the very aggressive monetary policy response and what we're likely
to see in terms of fiscal policy."
Indeed, some market indicators are signaling more expectations
of inflation rather than deflation -- or at least the economic
growth that usually accompanies rising prices.
Gold, a hard asset that can hold its value while prices rise,
has risen more than $60 from the start of the year, or about 7%, to
about $948. Copper, the metal analysts term "Dr. Copper" for its
ability to forecast economic growth, has also rallied about 9% this
year after tumbling 54% last year.
Yields on Treasury bonds have moved sharply higher since the
start of the year, though some analysts say that's largely a result
of the massive amount of new Treasury debt flooding the market.
Regardless of these recent market moves, the Federal Reserve is
pulling out all the stops to avoid a replay of Japan's run with
deflation or a scenario closer to home -- the slump in prices that
accompanied the Great Depression.
The worry about deflation comes from the top. It was Fed
Chairman Ben Bernanke's November 2002 speech on preventing
Japanese-style deflation that earned him the nickname "Helicopter
Ben" for his reference to policy-makers' willingness to air-drop
money onto the economy to keep consumer prices rising.
Today's Fed and Treasury intend to shower the financial system
with at least $2.6 trillion via bond purchases and guarantees,
capital injections to banks and cheap loans to financial
intermediaries.
Pensioners win, borrowers lose
Central bankers know that few benefit from a protracted period
of deflation.
In Japan's 1990s, retirees with fixed incomes were happy as
goods prices fell. But Japanese workers were hurt by lost income as
the unemployment rate breached 5%. That's low by U.S. standards but
it marked the highest levels since Japan started keeping detailed
statistics in the early 1950s.
"What was good for the retirees wasn't necessarily good for
anyone else," said Barry Eichengreen, professor of economics at the
University of California, Berkeley.
Sustained falling prices hurt anyone who owes money, such as a
homeowner with a fixed mortgage. Grocery and gasoline bills fall
when deflation is rampant. But homeowners and other debtors have a
harder time making fixed monthly interest payments if struggling
employers clip bonuses and lower wages.
The same goes for companies that have borrowed for capital
purposes and face a cash crunch as sales founder.
"It's your nightmare scenario," said Myles Zyblock, chief
institutional strategist for RBC Capital Markets. "You could have a
fresh wave of bad debt."
Banks stand to get cheaper funds, as savers sock away more
money. The U.S. savings rate has climbed to 3.6%, surging from near
zero during the last two years.
But a richer trove of deposits probably would not be enough to
offset other pains that accompany deflation -- such as higher
defaults. Just like in today's housing market, falling prices make
it hard for the borrower to sell assets to pay off a loan. And the
lender is left holding collateral that's worth a lot less.
"Funding may benefit the banks while people with capital who are
risk-averse may want to move into the banking system," said Jeff
Davis, director of research at brokerage Howe Barnes Hoefer &
Arnett who is also a bank analyst.
But if asset values keep falling, as they have in the housing
market, "by definition, bank capital comes under pressure."
That pressure has already crushed the stock prices of giant
lenders like Citigroup (C) and Bank of America Corp. (BAC),
ushering in a new era of government ownership in the banking
sector.
Gas and milk, cheaper by the gallon
Economists and policy-makers have been watching U.S. consumer
spending contract, prices flatten and savings climb.
So far, official deflation -- regarded by academics as a broad
decline in prices over at least a year -- hasn't materialized. It's
come close, however. The U.S. consumer price index rose 0.1% in
December from the prior year, the smallest increase in 54
years.
Month to month, consumer prices have fallen for four of the past
five months.
Most notably, the price of gasoline and milk both have dropped
more than 40% in the past year, and used car prices have slid 8%.
Clothing is down 1%.
Wages and benefits are still growing, but at a slower pace, as
companies from Caterpillar (CAT) to Boeing Co. (BA) to Starbucks
(SBUX) to AT& T (T) cut jobs.
The employment cost index rose at its slowest rate in at least
26 years last year.
Deflation is likely to occur this year if oil prices stick near
$40 -- or less than half their levels a year ago. Economists
surveyed by The Blue Chip Economic Indicators anticipate consumer
prices will drop 0.8% this year.
'Malign deflation'
U.S. consumers are used to seeing the price of manufactured
items like laptops and T-shirts fall year after year while
commodities prices make big swings. Earlier this decade, oil prices
traded under $12 a barrel.
Such deflation isn't bad news because prices are falling as
companies find more efficient ways to make products. Wealth is
created in that process as people's buying power and standard of
living rise.
But this time around, prices are mostly being driven lower by a
damaging drop in demand, which raises alarm bells.
The International Monetary Fund sees many of the same pressures
around the globe. It estimates the risk of "malign deflation" is
much greater to the world economy than during the 2002 to 2003
deflation scare.
"If inflation is falling by 2% a year, people won't buy a car or
TV, because they know anything they'll consider buying will be
cheaper next year," said UC Berkeley's Eichengreen. "If no one's
buying, no one's producing and no one's hiring - that's the problem
we are trying anxiously to avoid."