JANUARY 4, 2002 SOUND MONEY by Christopher Farrell

JANUARY 4, 2002
SOUND MONEY
By Christopher Farrell

Consider This Deflation Scenario

Though it's a real long shot, a new era of falling prices in America could be at hand. Here's why

So what will the new year bring? After reading a number of reviews of 2001 and forecasts for 2002, a consensus has emerged among the Wall Street forecasting fraternity that could be summed up as "better, but not great."
Such a well-hedged, modestly upbeat prediction seems reasonable enough, especially considering all the uncertainty unleashed by September 11. Still, forecasting is a hazardous exercise, so it's always productive for business and investors to think about where the consensus could be wrong -- and in a big way.
So far, I haven't found the argument for a rapid return to a late 1990s-style boom particularly convincing. The risk that the U.S. economy sinks into Japanese-style stagnation is real, but the odds seem remote. I'd like to make the case that the big surprise in the next several years could be economic deflation.
LIMITED GROWTH. What are some implications of mild deflation? For one thing, greater U.S. consumer purchasing power as a dollar earned today would buy more goods and services. But the negative impact is far-reaching.
In an environment where markdowns are more common than price hikes, corporate profits suffer. A deflationary world is one of single-digit earnings growth and meager stock market returns. Business and individual bankruptcies could soar above already high levels as debt burdens become increasingly onerous. Federal policymakers would face sophisticated lobbying campaigns from industries seeking to block competition from efficient producers based in developing nations. Smart business execs would be wise to factor such a scenario into their planning.
Inflation typically declines during a downturn, and the current recession is no exception. The consumer price index (CPI) has dropped to less than a 2% annual rate from a high of 3.7% last spring. Retailers are slashing prices to lure consumers into shopping malls. The prices for retail goods excluding vehicles and gasoline are some 1% lower compared to a year ago, according to Mark Zandi, chief economist at the consulting firm Economy.com. Import prices, excluding energy, have fallen 5% during the downturn (10% if you include energy), paced by a 7% decline in prices for information-technology goods.
OTHER FORCES. The trend toward mild deflation is not just cyclical, however. Powerful structural shifts in the economy will keep the pressure on for lower prices even as a modest recovery unfolds. For one thing, prices keep falling rapidly in the technology area, and high tech makes up an ever-larger part of the U.S. economy. Also, the global economy is prone to excess capacity and supply of all kinds of goods, especially as emerging markets devote more resources toward building up export industries.
China's emergence as a giant low-cost producer following its formal admission to the World Trade Organization on Dec. 11 will put enormous downward pressure on prices, points out Edward Yardeni, chief investment strategist at Deutsche Banc Alex. Brown.
Deflation, not inflation, was the normal economic condition throughout U.S. history before World War II. America's wholesale price index essentially remained unchanged between 1790 and 1945. The underlying dynamic was toward mild deflation, punctuated by short bursts of virulent inflation (usually during war years) and debilitating bouts of severe deflation (typically during a downturn).
GRADUAL DECLINE. Indeed, inflation has been the modern disease. The CPI rose at an average annual rate of 4.1% from 1950 to 2000 -- steep enough to cut the value of a dollar by more than 75%. But inflation has gradually declined to an annual range of 2% to 3% in the past 15 years. The U.S. may be on the verge of a period in which stable to falling prices become as commonplace as rising prices were from the 1960s to the 1980s.
I don't want to raise too frightening a scenario here. Deflation is a forecast on the further-out margins of probability. The consensus view holds that the recession should end sometime during the first half of the year, and the scorekeepers at the National Bureau of Economic Research are expected to label it the mildest downturn of the past half century.
However, the subsequent expansion also is likely to be unusually muted for a post-World War II rebound. One reason: Because sales of big-ticket items such as homes and cars have remained strong during the recession, consumers have little pent-up demand. Another factor is that business investment in high-tech gear likely won't pick up until late in the year.
NEXT SURPRISE? The stock market should show a modest gain, a welcome respite from the losses of the past two years. As the economy improves, interest rates probably will increase slightly, as will the inflation rate. The Fed could start tightening monetary policy once the unemployment rate begins trending lower after peaking at 6.2% to 6.5%.
The great unknown in any economic forecast for 2002 is the horrendous possibility of another major terrorist attack against Americans. But if a major economic surprise is in store over the next several years, it could be how the U.S. went from half a century of worrying about inflation to figuring out how to cope with widespread deflation.
Farrell is contributing economics editor for BusinessWeek. His Sound Money radio commentaries are broadcast over National Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BusinessWeek Online
Edited by Beth Belton