Are Deflation Worries Overdone?
Deflation, which is
defined as a broad decline in price levels, is now the buzz word after the Fed mentioned falling prices in its statement earlier this
month. As a result, treasury yields are hitting new lows as investors are
anticipating additional Fed easing while at the same time they are eliminating
inflation risk from fixed income instruments. But the likelihood of a
deflationary spiral, similar to the one now gripping Japan, are very slim. In
fact, certain members of the Fed Board of Governors have admitted that the odds
of deflation will occur are small, witness the Cleveland Fed report released on
Monday that stated “it seems clear to us that a good deal of deflation angst is
misplaced.” And I would agree for the following reasons….
First, one of the primary economic problems that
arises during periods of deflation is that demand for goods collapses. The
reason for this is that consumers delay making their purchases since they know
that goods will be even cheaper as time progresses–declining prices increase
consumer purchasing power over time. Currently, however, demand has been growing
at about 4% for the last three quarters, which is hardly typical during
deflationary cycles. Moreover, demand should continue in the months ahead as
cheaper energy prices and potential tax cuts help move things along.
Second, although the prices of certain appliances
and machinery have been declining for the past few years, the opposite has been
happening for other important goods & services–especially for education,
healthcare and housing. Again, this behavior is atypical during a deflationary
environment, as deflation is a broad decline in prices.
Third, some of the recent declines in the price
of airfares, hotels and resorts were temporarily caused by fear and uncertainty
about the war in Iraq, SARS and terrorism and should pick up in the months
ahead. Additionally, a weaker dollar will keep American vacationers home and
encourage foreign vacationers to visit the US.