Meltdown 101: What's deflation, and why is it bad?

[November 19, 2008]  NEW YORK (AP) -- Deflation might sound like a good thing. Yet it can be even rougher on the economy than the more familiar phenomenon of inflation, because it's harder to get rid of.

In the past year, record-breaking prices for oil, grains and metals caused serious worries about runaway inflation. And as the economic slump took hold, economists even considered the possibility of stagflation -- a period of rising prices despite slow economic growth.

But now, as the economic downturn continues, concerns are shifting from rising prices to the opposite extreme: the possibility of a destabilizing bout of deflation.

Here are some questions and answers about deflation:

Q: What is deflation?

A: It's a period of recurring declines in overall prices -- though it can happen in specific markets, too. In August, home prices were down 16.6 percent from August 2007 levels, while oil prices have plunged about 40 percent from a year ago.

Q: What causes deflation?

A: Falling consumer demand is a key trigger, as it forces companies to cut prices as they try to encourage buying. Consumers are nervous about rising unemployment and investment losses, and tight credit markets are limiting borrowing; as a result, people are spending less. Consumer spending in the third quarter fell the most it has in 28 years.

A stronger dollar also contributes to deflation -- it causes import and commodities prices to fall, pushing down overall price levels.

Q: Lower prices sound good. Why is deflation bad?

A: Any price instability is not good for the economy. The pattern of falling prices is hard to stop because it feeds on itself, similar to spiraling inflation. Look at the housing market: As prices decline, would-be buyers are putting off purchases in hopes of getting a better discount later, and that drop in demand can lower prices further.

During deflationary periods, companies taking in less money react by slowing production and cutting jobs, which causes consumers to scale back spending even more.

Q: When have we seen deflation?

A: The U.S. hasn't seen year-over-year declines in the Consumer Price Index for almost six decades, and those periods didn't occur during bear markets like the one we're in now. If deflation does occur in the U.S., it will be something most people haven't experienced, says Merrill Lynch economist David Rosenberg.

Disinflation, or a slowdown in inflation that might turn into deflation, is more common -- it happened in 1961 and 2001.

Tuesday's Producer Price Index showed a record 2.8 percent drop in wholesale prices for October, while CPI, which is due Wednesday, is expected to show slowing inflation for a third consecutive month.

Q: So deflation rarely happens?

A: While it's uncommon in the U.S., the Japanese economy has struggled with deflation since the 1990s. It can prove pernicious once it settles in. The Japanese government said it eradicated deflation in 2006, but the threat is back. The Bank of England also recently said it's worried about the prospect.

Q: What can governments do about it?

A: To fight inflation, a central bank can hike the target for its benchmark interest rate as much as it pleases. Higher rates ease inflation by making it more expensive to borrow money, which cools the cycle of borrowing, lending and spending. That pushes down demand -- and, in turn, prices for goods, services and raw materials.

The opposite medicine is used in a deflationary period -- you lower rates, which makes borrowing cheaper and encourages people to spend, leading to higher demand that pushes up prices of goods and services.

But the Federal Reserve has already slashed rates from 5.25 percent in early September 2007 to the current 1 percent. If deflation were to strike, the central bank has very little room to cut rates.

Q: Hasn't the government pumped money into the financial system, which should cause inflation?

A: It's only inflationary if the credit markets are working properly -- and they aren't. It doesn't matter how much money the banks have right now, or how cheaply it can be borrowed -- if the banks won't turn around and pump that money back into the economy through consumer and business loans, deflation remains a risk.

Q: So are we headed for deflation?

A: It depends on whom you ask. Rosenberg says deflation is in its "infancy stages" right now, but he expects it to take hold within a year. JPMorgan economist Michael Feroli says it's a "legitimate concern." Moody's Economy.com analysts say it's unlikely, but could be an issue in 2009.

Q: What can investors do about deflation?

A: Bonds with safe yields are a good bet in a deflationary environment, when fixed-income returns increase their buying power as prices fall, says Ned Davis Research analyst Joe Kalish.

Stocks are trickier. Rosenberg says investors should favor companies with healthy balance sheets, as high debt becomes an added burden. Financial stocks could suffer for that reason, while retailers could go through tough times as they make less money off the goods they sell.

Sectors that sell necessities like consumer staples, health care and utilities are good places to look, as they are considered safe during unsteady economic times.

[Associated Press; By SHAILA DANI]

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