Deflation: What Investors Need to Know

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Gas Down 55.4% in Three Months

Firms are forced to cut prices further to keep business, an environment that is "very challenging to corporate profits," says First American Funds Chief Economist Keith Hembre. With prices and profits falling, companies cut staff, delaying a recovery for the labor market. The U.S. unemployment rate rose from 6.1% to 6.5% in October, and many economists expect that to rise further.

According to the October CPI report, gasoline prices are down 55.4% in the last three months. Levitt says those savings to consumers far exceed the total amount of income being lost from job cuts—at least at this point.

Despite this, consumers are in no mood to spend. "People are hunkering down," says Josh Feinman, chief economist at Deutsche Bank Advisors (DB). "Whether businesses or households, they're deferring spending."

Truckers Cutting Prices

Consumers, banks, businesses—worried by the economic environment—all seem to be putting cash in the bank rather than jumping at the new, bargain prices. For U.S. companies, the result of all this deflation and hoarding of cash is likely to be weak sales figures and shrinking profits.

That's true even of firms that benefit from falling commodity prices. For example, Longbow Research analyst Lee Klaskow, who covers the trucking industry, wrote Nov. 18 that diesel prices have fallen about 41% from July. That's good for trucking firms, but almost everything else looks bad for truckers. In a Longbow survey, about 70% of trucking companies "stated that they are experiencing weaker demand year over year and that the decline is gaining some momentum," Klaskow wrote. So, truckers are making "aggressive and at times irrational" cuts to the prices they offer customers.

With companies under pressure from falling earnings, a weak economy, and the hoarding of cash, fewer investors are willing to buy stocks during deflationary times. It's a tough environment for equities, Hembre says, though it is a positive for Treasury bonds. With prices falling, bond yields offer a safe return that easily beats inflation.

Inflation Will Come Back

The solution, many economists insist, is strong action by the Federal Reserve and the federal government to pump liquidity into the financial system and stimulate economic demand again. In a Nov. 19 speech, Federal Reserve Vice-Chairman Donald Kohn addressed the issue. "Kohn sees the risk of deflation as small, but the economy is very weak and it's important to be aggressive to head off any such risk," wrote Action Economics in an analysis of the speech. "The government is throwing the biggest stimulus in U.S. history at the problem," Levitt says. "Given the amount of the stimulus, we do believe that policy will eventually win out."

Some worry all this government money will spark inflation down the road. If that happens, central banks can pull back on the liquidity, Feinman says. But that's not a serious worry now. "With the economy so weak, inflation is not our concern," he says.

Given the threats to the economy and the global financial system, a little inflation might be a good problem to have.

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Steverman is a reporter for BusinessWeek's Investing channel.