Deflation: What Investors Need to Know

A rapid drop in inflation may help shoppers' dollars go further, but it's a disturbing trend for investors

By Ben Steverman

Forget inflation for now. Prices are falling on almost everything, including stocks.

Investors need to adjust to a new reality: A few months ago, inflation was a top worry, especially the impact of sky-high fuel prices. Now, although consumers can celebrate falling prices at the gas pump, investors' worry is exactly the opposite.

Instead of inflation, the problem is deflation, a downward drift in prices that could squeeze corporate profits and investor returns to uncomfortable levels.

PPI Posts Record Decline

On Nov. 18, a government report showed an unexpectedly large 1% drop in the October consumer price index, including an 8.6% plunge in energy prices last month. Excluding energy and food, the CPI fell 0.1%, the first drop in the so-called "core" index since 1982.

On Nov. 17, the producer price index, a measure of wholesale prices, fell 2.8% in October, including a 12.8% fall in energy prices. That was the largest decline in the PPI in the report's 61-year history.

After a fast rise in prices in early 2008, consumer prices are still up 3.7% in the past year, though that's down from a 4.9% annual increase in September.

Economy Facing "Extreme Stress"

Economists say the recent price declines do help consumers (BusinessWeek.com, 11/19/08).

However, rampant deflation is also a sign of the extreme stress the economy is under right now. "Clearly, demand is down worldwide," says Brian Levitt, economist at OppenheimerFunds (OPY).

Falling prices—for everything from commodities to airline tickets to apparel—are a sign of how much economic activity has slowed. For example, consumer energy prices are off 43.1% in the past three months. In October alone, airfares dropped 4.8%, and apparel prices dropped 1%.

Deflation Can Be Destructive

In a sign of manufacturing's weakness, John Ryding of RDQ Economics points out that scrap steel prices have fallen from a high of $523 per ton in August to $144 per ton last week.

Falling prices aren't just a symptom of economic weakness, they're also destructive in and of themselves. "A deflation spiral is probably the biggest risk to the economy," Levitt says.

As demand declines and prices fall, companies cut employment and investment, slowing economic growth even further.