Facing Up to the Possibility of Deflation

Practical and relevant business responses for uncertain times

2003 Volume 6 Issue 3

Business people need to know how to recognize the signs should a deflationary spiral begin and how to prepare ahead of time with practical relevant business plans and strategic initiatives.

Over the last twenty years inflation spirals in the U.S. have decreased. Some economists attribute the increased stabilization to the aggressive interest rate policies of the Federal Reserve. Others disagree. Regardless of the interpretation, when inflation occurs today there is some certainty about what actions the Federal Reserve will take. Recently, however, the Federal Reserve raised the possibility that deflation could emerge, in which case the future would be far less certain.

The deflation announcement by the Federal Reserve earlier this year was not a unilateral, dire prediction that a substantial fall in prices would occur. Rather it was a notice that the Federal Reserve is watching downward price movements and is considering appropriate future actions. It was also a wakeup call to businesses, suggesting that managers prepare practical, relevant business plans and strategic initiatives to deal with falling prices in the U.S. economy if they occur.

Recognizing Deflation

Economists define deflation as a decline in the average price of the products and services in a market. Deflation can occur from a shift down in spending or a shift out of the production curve. Short periods of deflation are a natural consequence of the business cycle.[1] However, in a period of increasing prices a substantial fall in inflation only results when a shock or decline occurs in a major market, such as the housing market. Such a decline becomes unwelcome when it triggers an extended spiral of lower spending. Spirals of decreased spending have been historically recorded in the U.S. For example, in the period from 1880 to 1896, average prices fell by 23 percent. However, this downturn occurred well before the Federal Reserve was chartered as the U.S. Central Bank. Countering the negative economic effects of substantial and prolonged deflation is uncharted territory for today’s Federal Reserve.

A substantial fall in prices with an associated spiral is a multiple period experience. Over the last twenty years, monthly general price decreases occurred on several occasions, but none of these short-term changes turned into a prolonged deflationary spiral. The lesson should be that businesses must distinguish between deflation and a deflationary spiral.

Using the CPI to Track Deflation

While there are several indices that monitor the pattern of price movements in markets, the most commonly used pricing movement series is the Consumer Price Index (CPI). Deflation is said to occur when the CPI value in one period is less than its value in the previous period.

But using the CPI to track general deflation or inflation can be risky since the CPI is an oversimplified abstraction. Two basic flaws make the CPI inaccurate as a stand-alone measure of deflation or inflation. First, the bundle of goods and services used for the CPI comparisons is only updated once every ten years, and the current bundle is nearing the end of its life cycle. Consequently, many of today’s goods and services are not included in this bundle. This is significant because new products and services tend to contribute more to deflation than do long-existing ones. The prices of new products tend to fall from high launch positions to longer-term competitive price levels over two to four quarters.

The second flaw in using the CPI to track deflation or inflation is the fact that consumers may substitute lower-cost goods and services for those that have increased in price. In economic terms, the CPI does not allow for substitution by consumers.

Stanford University economist Michael Boskin found that the CPI overstated inflation by as much as 1.0 to 2.0 percent.[2] While some economists argue that Boskin’s findings are too large and others find that they are too low, the Bureau of Labor Statistics (BLS) continues to work on a CPI option called the COL-I index, which allows for substitution. Viewing Boskin’s findings as a compromise until the BLS adapts the CPI methodology, businesses can take away 1.0 to 2.0 percent from the reported CPI change to estimate the current rate of price change. If the adjusted price change measure is less than zero, the economy is actually in deflation. Finding negative price changes over consecutive months or quarters can reveal that an underlying deflationary spiral has begun. But what can businesses do to recognize and understand the dynamics of a deflationary spiral?

The Dynamics of a Deflationary Spiral

A deflationary spiral has both an igniting event and an on-going force that leads to a substantial spending decrease. The force that feeds the spiral can be simple confusion. As the Japanese economy has shown us, near zero market interest rates can create a potential for confusion in financial markets. If borrowers and savers become confused by such rates, they can stall the economy’s investment growth. Why does this confusion occur?

Confusion As a Factor

If deflation begins during a period when nominal interest rates are very low, as may be the case now, borrowers may not realize that the dollars they will have to pay back in the future will be more valuable than the dollars they borrow today. This can lead them to borrow not only more than they should, but more than they can pay back. At the same time, savers find themselves unwilling to put monies in financial institution accounts at low interest rates even if the rates are positive. These are uncharted waters that can lead to sub-optimal decisions.

In confusing economic times, financial institutions anticipate deposits that do not occur, so that cash flows tighten and insolvency problems increase. The real investment problem occurs when borrowers, especially businesses that want to invest in new plants, equipment, software and inventories, cannot easily find available capital in financial institutions. If the Federal Reserve reduces interest rates to increase investment, a lack of deposits in financial institutions circumvents the desired financial flow process.

The Federal Reserve reports the amount of cash held by the public on its Federal Reserve data site (FRED II). Specifically, the monetary base includes the cash held by the public and the reserves held by financial institutions. A ten percent rise in the monetary base during a period of deflation can be a signal that businesses are reluctant to borrow, savers are reluctant to leave monies in institutions that are paying low positive interest rates, and confusion exists in the money market.

The U.S. is currently in a period of low interest rates. Financial markets and government regulators are not sure what to expect. If investors do not properly anticipate the higher future costs of borrowing, and savers overreact and reduce deposits more than expected, the economy can grow in the short term but will slow down in the long term as corrections are made. In such a period why would the Federal Reserve continue to reduce interest rates? A logical answer is to ward off the root cause of an unwelcome and substantial decrease in consumer spending.

Potential Igniting Event

At this point the most likely igniting event for a deflationary spiral is the housing market. Housing has been the pillar of the economy lately, and mortgage refinancing and equity loans have provided money for consumers to spend. These sources of funds are so important that the Open Market Operations group has been systematically lowering the rates on ten-year treasury bonds by purchasing them in the secondary market. Selling the bonds to the Federal Reserve provides financial institutions with additional funds to pump back into the mortgage market. This increased flow of funds keeps mortgage rates down. Businesses can track the Federal Reserve’s purchasing pattern for ten-year treasury bonds to monitor the level of support that the Federal Reserve is providing to the housing market.

But is this prescriptive action by the Federal Reserve enough to defuse a deflationary spiral? The outcome is uncertain. Businesses should monitor changes in the housing market to find the answer. If a reduction of seven percent in housing prices occurs, an important milestone will be reached since current 107 percent equity loans fall below the water line.

Besides watching the trend in housing market prices, housing sales and re-financing activity levels, businesses can watch for concurrent downward movements in the consumer confidence index and in housing market statistics. The Conference Board reports changes in consumer confidence as a key factor in its leading economic indicator series. Recent changes in consumer confidence have been up in some months and down in others. If the levels of consumer confidence shift down for three consecutive months and the housing market turns down during the same period, businesses can assume that a deflationary spiral is in its early phase.

Confusion in the money market, actions by the Federal Reserve to support the mortgage market, decreasing housing activity levels, falling equity values, and declining consumer confidence can all be used as warning signs of a deflationary spiral. But what can businesses do to respond to a deflationary spiral?

Practical and Relevant Business Plans for Deflation

Interest rate risk and exchange rate risk are just as real in deflationary times as in inflationary times. The management of these uncontrollable risks and of controllable factors—marketing initiatives, research and development efforts, pricing, cost management, and productivity—can be addressed in business plans.

In summary, the following ten actions are practical, relevant business guidelines for responding to deflation if it occurs:

  • Continue tracking CPI movements and published predictions from reputable forecasters, such as UCLA and the Wharton School. To more accurately determine the actual deflation rate, take the reported inflation rate using the CPI and decrease it by 1.0 to 2.0 percent.
  • Revisit the benefits and risks of using general price indices to track price movements in your market. Calculate the ratio of price movements in your market relative to the economy. If the ratio is greater than one, prices in your market are likely to fall faster than the average price. Prepare to implement additional cost-reduction programs to offset declining revenues.
  • Review and update your interest rate management hedges. Watch the bond confidence index to assess the potential for future stock price changes. Watch for parallel downward movements in the consumer confidence index and declines in the housing market. If these occur, be prepared to postpone capital investment projects.
  • Adjust international sales targets if prices of U.S. products and services continue to fall relative to other important national and regional market economies. Purchasing power parity rules indicate that countries with less relative inflation can expect stronger future exchange rates.
  • Consider when possible the benefits and costs of writing some international sales contracts in foreign exchange currencies rather than in U.S. dollars. While the U.S. currency is supposed to increase in value if inflation is lower than price changes in other economies, the effects of higher deflation are much less certain.
  • Recognize and track multiple pairs of economic factors, such as housing activity patterns and the purchases of ten-year treasury bills by the Federal Reserve. Pay special attention to the health of your financial partners, especially if they are over-extended in equity home mortgages. If equity drops by seven or more percent over a period of months, revise sales targets downward in the next quarter.
  • Remind employees that deflation can add negative cost of living amounts into future wage payment formulas. Reassure employees that increases in their take home compensation depends on increased productivity.
  • Look for opportunities to reclaim market share that was previously lost to cheaper foreign competitors.
  • Examine how the political cycle will affect government actions in this pre-election year. With terrorism security and cost concerns increasing and deficit spending on the rise, legislative agendas are expected to move even more slowly this cycle than in previous pre-election years.
  • Don’t act on information from a single period. Track patterns of change and flag changes that occur across two or more consecutive periods. Be ready to act when deflation builds over three consecutive periods along with other key indicators.

[1]According to the Bureau of Labor Statistics the seasonally adjusted, U.S. city average CPI price change in April 2003 was minus 0.3 percent. Using this same measure, general price decreases were also recorded in February 1999, April 2000, and July and October 2001.

[2] As reported in the Federal Reserve Bank of San Francisco’s February 5, 1999, Economic Letter, entitled “A Better CPI” , Michael Boskin reiterates his research findings prepared for the Senate Finance Committee.

About the Author(s)

Donald M. Atwater, PhD, is a practitioner faculty of economics at the Graziadio School of Business and Management. Previously, he served as chief executive for a southern California technology company, the chief financial officer of an international, value-added software company, a principal in the human resources and compensation practice at William M. Mercer, and a director and co-founder of several start-up companies. He has created decision-support technologies and implemented them in a number of Fortune 100 companies, including AT&T, Intel, Dell Computer, Apple Computer, and Nestle USA. Dr. Atwater has also worked with many public organizations, including the U.S. Navy, the General Accounting Office, the state of California, and both the county and city of Los Angeles. His work has been published in the Monthly Labor Review and he has co-authored numerous papers. Today he owns and operates a company dedicated to building goal-driven communities.

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