Working Thoughts

There is a term causing many economists and government officials to get
nervous – Deflation. As bad as run away inflation is, deflation is even
more sinister. Deflation is the continual lowering of prices across all
goods and services. It is mainly in the minds of consumers though. It
is the belief that you, the consumer, can get a better deal by waiting.
This perpetuates poor demand and supply must keep trying to catch up by
lowering prices and on and on it goes.

But as noted in two good overviews on Deflation (Finding Good News in Falling Prices in the NY Times and Deflation is an empty threat (so far) on CNNMoney.com) the dramatic price drops, as reported by a metric called CPI, are coming mostly from commodities. I’ll bet you’ve noticed the price of gas is lower than you probably ever thought it would get? That is because the price of oil has dropped from $145 for a barrel to about $43 a barrel. Other items like copper are dropping in price as well. It makes you wonder why the price of commodities were so high to begin with (much of it was the building of emerging markets like China and India, but some of it was pure speculation). $145 isn’t the true value of a barrel of oil and neither is $43, these are extremes. But the price decline is now leveling off. So items associated with commodities will not drop in price at the same rate as they did from the end of August, 2008 until early December, 2008.

But this argument mostly sides with sellers tolerance for lowering their prices because their margins were still healthy enough. That will not be the case if demand continues to shrink as is expected. Why? Rising unemployment. As more people are out of work, they will only spend on necessities like peanut butter and milk. But it is only true while the unemployment rate is rising. Once it begins to level off and and stabilize, consumers will increase their spending again. The beauty of layoffs is that it ensures those that still have jobs will maintain their compensation level. It is rare to see wage cuts. This drags out the problems much longer, for both the company and the economy. Here is a good excerpt from the NY Times piece:

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Traditional economic theory doesn’t do a good job of
explaining this. During a recession, the price of hamburgers, shirts, cars and
airline tickets falls. But the price of labor does not. It’s sticky. (excerpt
this. So succinct)

In the 1990s, a Yale economist named Truman Bewley set out
to solve this riddle by interviewing hundreds of executives, union officials
and consultants. He emerged believing there was only one good explanation.

“Reducing the pay of
existing employees was nearly unthinkable because of the impact of worker
attitudes,” he wrote in his
book “Why Wages Don’t Fall During a Recession,” summarizing the view of a
typical executive he interviewed. “The advantage of layoffs over pay reduction
was that they ‘get the misery out the door.’ ”

The average employee, who didn’t get any real wage increases for six years (data shows that wages didn’t recover from the recession of 2001 until 2006, when adjusted for inflation) is certainly not going to get one this year. But the good news is they will actually see an improvement in their buying power due to these lower costs. Although I’m skeptical about the survival of the social contract corporate America has with its employees i.e. benefits like inexpensive healthcare.

What remains to be seen is whether the spending habits are tempory or permanent. Paying off debt is now a priority and I expect that value to persist – to a point. There are so many intelligent consumers that can quickly calculate the cost of financing against the benefits of the investment.

These different influences will work together to moderate prices, but they aren’t enough to induce deflation.