An eye on deflation

When central bankers get together and stay up late telling spooky stories, the one that really gets them is the one about the deflationary spiral. I'm sure there are a lot of those stories being told this week at the gathering of the world's elite in Davos, Switzerland. And with good cause. While central banks have a huge box filled with inflation fighting tools, they really have only one thing to use against deflation: lower interest rates. Unfortunately, that doesn't always work.

Inflation is a monetary phenomenon. As Milton Friedman described it, inflation stems from too much money chasing too few goods. The way to fight inflation, therefore, is to reduce the amount of money floating around. As the money supply is reduced, economic growth slows, demand for goods goes down and market prices adjust to balance supply and demand. (My economist friends would cringe at this simplification, but it captures the main idea.)

A deflationary spiral, on the other hand, is primarily a problem with confidence. Lower demand leads to lower prices, which leads to lower production. Falling production leads to lower employment which, in turn, leads to even lower demand and an accelerating vicious circle is established.If you think back over the implosion in our economy over the past 18 months you can probably identify this type of pattern emerging. There is a systemic slackening of demand that is translating into declining price levels, i.e., deflation. We have yet to see a full blown deflationary spiral, but we are starting to see the outlines of what could become one.

The Fed acknowledged this risk in its press release earlier today:

In light of the declines in the prices of energy and other commodities in recent months and the prospects for considerable economic slack, the Committee expects that inflation pressures will remain subdued in coming quarters. Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term. (Federal Reserve Press Release, 28 January 2009)

The risk we face as investors is that equities do not tend to do well in deflationary spirals. Equity prices are driven by profit expectations and profits deflate as prices deflate. A persistent spiral would translate into persistent profit erosion. In fact, the major collapse in equity values last year was probably due, in large measure, to the market discounting the likelihood of future deflation.

The question we now have to ask ourselves is whether the current deflation develops into a full deflationary spiral. For the record, I tend to doubt it. Our current problems are almost completely attributable to a broken financial sector. If we fix that, the other problems will tend to heal themselves.

At the risk of sounding like a broken record, the measures being taken to finally get the toxic assets off bank balance sheets should go a long way to addressing the underlying confidence problem. This doesn't mean we are out of the woods, but it does lay the foundation for economic recovery and an associated improvement in asset values.