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Get Four
|  | DECEMBER 18, 2003
By Christopher Farrell Is Deflation Defeated? Don't Bet on It Economists are ready to write it out of the picture, but that doesn't mean it's gone -- and maybe that's a good thing Let's review some recent economic numbers, first on the growth side of the equation. Industrial production came in well above consensus expectations. Single-family construction hit another record high. Retail sales are robust. The latest Manpower Survey shows the labor market improving across industries and regions for the third consecutive quarter. The economy is on track to post a 5%-plus average annual rate of growth over the same time period. The latest Bloomberg survey of economists pegs next year's growth rate at 4.4%. These are heady numbers, considering the state of the economy and markets over the past three years. Now, how about prices? The research reports that come my way suggest Wall Street economists are anticipating higher prices next year, although any increase will be modest. The economy is strengthening. And the Fed has run an easy-money policy for three years. That combination traditionally translates into an inflation spiral. Yet I would argue that deflation will be around for quite a while despite the strength of the economic recovery. ANOTHER DROP. The majority of economists interpreted the Dec. 9 Federal Open Market Committee release as a signal that the Fed was no longer concerned about deflation, that the era of low interest rates was coming to an end, and investors should be prepared for a rate hike at some point. The betting on the Street is the Fed will tighten in the first half of the New Year. Still, the consumer price index, the government's widely followed measure of inflation, fell 0.2% for November. The core rate of inflation, the CPI minus energy and food, dropped 0.1%, breaking through a 38-year low reached just two months ago. And the producer price index, measuring prices at the wholesale level, fell at a 0.3% rate in November. That was well below what Wall Street economists predicted. Core prices fell by 0.1%. The CPI typically drops early in an expansion. Yet something else is going on here. David Rosenberg, chief North American economist at Merrill Lynch, cautions his fellow members of the analytical soothsaying fraternity that maybe they misinterpreted the Fed release. "Yes, the Fed acknowledged that deflation risks are, at the margin, diminishing amidst the recent spurt in economic activity and the better tone to the business survey data," writes Rosenberg. "But it stopped short of telling the market that inflation risks, at this juncture, are equal to deflation risks." WRONG EXPECTATIONS. He says the statement pointed out that the gap between the two risks has closed in recent months (though not all the way: "almost equal" isn't "equal"). Indeed, Rosenberg wouldn't be surprised if Greenspan waits until the unemployment rate approaches the 5% level before tightening. That marker may not be reached until 2005. It could be that price expectations forged during an inflation-prone half century are wrong. This column has argued in the past that deflation is not a consequence of the bursting of the dot-com bubble or the 2000-03 weak economy. It reflects the commitment of central banks and capital markets to flee any currency showing signs of inflation, the rise of international competition, and the spread of the Internet. Evidence of further price-cutting came this week, as retailers lost their resolve to leave price tags alone during the holiday season and took out the markdown pen. The Wall Street Journal obtained documents saying IBM (IBM ) -- an American technology icon -- could off-shore some 4,700 programming jobs. The overall price level -- as opposed to certain sectors of the economy like cable TV and higher education -- doesn't rise in an environment like this. CAUSE AND EFFECT. Deflation, like inflation before it, is taking on a momentum of its own. "Of all the recording devices that can reveal to an historian the fundamental movements of an economy, monetary phenomena are without doubt the most sensitive," wrote French historian Marc Bloch. "But to recognize their importance as symptoms would do them less than full justice. They have been and are, in their turn, causes." Deflation reflects the rapid spread of capitalism domestically and internationally. Prices don't rise in an intensely competitive environment. Adam Smith wouldn't be afraid of deflation. In fact, he would approve.  Farrell is contributing economics editor for BusinessWeek. His Sound Money radio commentaries are broadcast over Minnesota Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BusinessWeek Online Edited by Beth Belton Get BusinessWeek directly on your desktop with our RSS feeds.  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