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The attention of policymakers and economists is trained mostly on a looming inflation threat, the drawback you typically associate with enormous amounts of liquidity pumped into the financial system and an economy rebounding from a severe recession. A negligible 0.1% rise in the March consumer price index and comments from the Federal Reserve that interest rates will remain very low for an extended time don't appear to confirm that risk, however.
Some economists and analysts see reasons to worry about the opposite scenario—a period of deflation if companies feel compelled to lower prices to jump-start demand in a sluggish economic recovery burdened by high unemployment. Consumers initially embrace falling prices, but if it becomes deep and pervasive enough, deflation will eventually push employers to cut wages and ax jobs, driving worried consumers into complete retreat. Perhaps most dangerous, deflation hikes the cost of repaying debt by boosting the value of the dollar.
That the value of the U.S. dollar is down 30% from its peak several years ago should have been sufficient to restore the U.S. to a fairly competitive trade position, even given the euro's recent decline, says Barry Bosworth, senior fellow at the Brookings Institution in Washington. But U.S. exports, which were robust in the first half of 2009, have disappointed since then. "For the U.S. to have a positive outlook, we have to have an export-led economy," he says. "We can't expect [domestic] construction to come back any time soon."
Strictly speaking, we're in a period of disinflation, defined by a decline in the rate of inflation, says Joseph Trevisani, chief market analyst at FX Solutions, a currency brokerage in Saddle River, N.J. Historically, prices were relatively stable for long periods and a moderate level of inflation is a modern development, he says.
Deflation, a drop in prices over a certain span of time, signals "a damaged or seriously problematic economy," he says. Disinflation increases the possibility of actual deflation occurring since any rise or fall in prices has to be seen on a continuum, Trevisani adds.
While some of the optimism about growth in the U.S. economy is justified and business conditions have improved over the past year, there isn't sufficient evidence yet to suggest the economy will be booming a few years from now, says Bosworth at Brookings.
"Unemployment will be a severe overhang for prices in the U.S.," he says. "We may have some pass-through in energy prices [that boosts consumer prices generally], but I can't see the labor market righting itself in the near future."
Bosworth sees no sign of pricing power in either the labor or the product markets. U.S. companies have been able to maintain high profit margins due to increased productivity and cost-cutting, not higher prices, he says.
A dearth of new construction projects is preventing manufacturers from regaining any pricing power, says David Gordon, a principal at Channel Marketing Group, a marketing consulting firm that advises manufacturers, distributors, and industry associations. With so much slack in the construction industry, distributors are going after the few scraps of business they see and are so focused on capturing market share that they're willing to give up pricing power, he says.
The plumbing, building materials, and electrical supply companies he works with aren't even passing through higher fuel and other commodity costs to their customers, he adds.
David Huether, chief economist for the National Association of Manufacturers, cites diminished pricing power in sectors related to housing—nonmetallic minerals such as cement, bricks, and glass, as well as furniture makers. But food and chemical manufacturers, which together make up more than 27% of the manufacturing sector, have been able to raise prices over the past year.
Food prices are up 2%, and that's only partly due to the pass-through of higher energy costs that have boosted transportation expenses for manufacturers, he says. Energy cost increases are also contributing to the 4% year-over-year rise in margins for merchant wholesalers, the middlemen between food producers and retailers.
Prices for chemicals—including pharmaceuticals and paints—have risen 3% since April 2009. Because many chemicals are feed products used to make other products like plastics, "chemicals are typically a good predictor of demand going forward for final products," says Huether.
Apparel prices, however, have dropped dramatically over the last several months, according to Charles McMillion, chief economist at MBG Information Services in Washington.
The decline in the money supply—one of the few factors that countered rather than contributed to the 1.4% uptick in the March Leading Economic Indicators data released on Apr. 19—is another red flag for deflation. There's been a remarkable collapse in bank lending since April 2009, mostly due to banks' efforts to conserve cash to pay back money received under the U.S. government's Troubled Asset Relief Program, according to Michael Englund, chief economist at Action Economics. That's one reason for the slow pace of economic growth, he says.
There's also significantly less demand for loans at the terms banks are willing to extend right now, says Jefferson Harralson, a bank analyst at Keefe Bruyette & Woods (KBW). No loans are being made in large categories such as construction, land, and commercial real estate, and he doesn't believe that banks that have repaid TARP money are more willing to lend than banks that still owe the government money.
What's so unusual about the current situation is the enormous amount of liquidity that's available but not circulating, says Trevisani. It isn't encouraging the kind of economic activity that typically would lead to higher inflation.
The 1.6% month-over-month increase in March retail sales and the general strength of consumer spending hardly support concerns over potential deflation. But spending is up at the expense of household savings, which have dropped much more quickly than most people expected, from between 6% and 7% of household income to 3.1% in February. McMillion at MBG Information Services expects the March savings rate, which hasn't been released yet, to fall to nearly 2%. He says he doubts that consumers will "be able to keep up with anything remotely like the spending we've had."
Had the savings rate stayed in the 6% to 7% range, prices would have come under more pressure than they are facing right now, says Trevisani. But the extension of unemployment insurance and other forms of government intervention have also made it easier for people who would normally be pinching pennies to continue to spend, he adds.
The prospect of new taxes threatens to weigh on consumer spending in the future, particularly if the economic recovery fails to boost job growth. The Bush Administration's tax cuts expire at the end of 2010 and the health-care reform bill contains new taxes that take effect in 2013. Congress is also weighing the possibility of a value-added tax to lower the federal deficit, and legislation aimed at reducing carbon emissions may add to consumers' tax burden in the future.
"The taxes that are coming don't seem to be affecting [consumer] spending a great deal yet, but it seems to be reflected in consumer sentiment numbers," which are falling, says Trevisani.
As long as hikes in wages and the prices of most consumer products are not viable for businesses, there remains a basic deflationary risk, says Bosworth. Even if you're inclined to believe the risks of inflation and deflation are balanced, were events to favor the deflation side, the Fed could do relatively little to fix it. The fed funds rate is already at zero, which leaves hardly any room to increase the money supply, and it wouldn't be productive to offer more stimulus money that would drive the federal deficit above 10% of GDP, he warns.
That tells him that inflation is actually a smaller risk than deflation: If it does materialize, it would be comparatively easy for the Fed to correct by raising interest rates and using other proven measures to slow activity in a booming economy. "There's no reason to fear that."
The specter of a stagnant economy for an extended time—like the malaise that has plagued Japan for the past two decades—is far scarier. "[U.S.] policymakers are praying that the economic growth will be sustainable and are not willing to choke it off," says Bosworth. The Fed will likely wait to raise interest rates, but it would make sense to keep unwinding "the extraordinary monetary measures" implemented over the last two years.