Deflation in August

With a coordination that I am sure both found embarrassing, The New York Times and The Wall Street Journal both ran stories on Saturday with tips on how to deal with a bout of deflation.Chicklet-currency

This raises several questions. Do we expect deflation? If so, why? What is deflation, anyway? Why is it so bad? Is the advice from these two giants of the mainstream any good? And what was it about last weekend that inspired them to write about, of all things, deflation?

That’s a long post’s worth of rhetorical questions. So, without further ado, let’s dive right in. Personally, I do not expect deflation in the near term, at least not enough to notice. Whether or not it is expected, or even seriously worried about, in the larger investment community is a harder question to answer.

The WSJ opens its piece telling us that “The markets are signaling that a bout of deflation may be coming.” But the only market indicator cited is a rally in bonds. True, the yield on 10-year Treasuries is down this year, although it is up from where it was at the end of 2008. And yet a rally in bonds is not exactly an unambiguous statement about deflation. The bond market goes up and down all the time. Why is this rally a deflation prediction?

Further, the WSJ rather strangely cites narrowing credit spreads, smaller differences between what corporate bonds and risk-free treasuries pay, as further evidence of deflationary expectations. If anything, the opposite is true. Smaller credit spreads suggest more investor confidence in the economy and, presumably, less worry about disaster scenarios that might include deflation.

The thing is, getting a market quote for deflation (or inflation) expectations does not require reading tea leaves. The Treasury sells inflation protected bonds, known as TIPS. If you compare what TIPS offer over inflation to the going rate on unprotected bonds you can back out the market expected rate of inflation/deflation. (Both articles mention TIPS, neither discusses the implied inflation prediction.)

The TIPS maturing in 10 years currently pays inflation plus 0.92%. Since the regular Treasury equivalent yields 2.70%, we can infer that the market expects an average inflation rate of 1.78% over the next ten years. That’s low, but it’s still positive. That is, the market expects inflation not deflation. (For reference, for the ten years ending June 2010 inflation averaged 2.35%.)

But maybe the markets are wrong. It’s happened before. Perhaps there are reasons why a wise person would expect deflation. Maybe so, but neither the Times nor the Journal provides any, other than pointing out that inflation has been low lately. They also cite a few experts warning of deflation, but do not share why these experts think what they do.

So what is deflation, after all? At the most basic level it is the mundane obverse of inflation, a situation in which average prices decline rather than increase. And in and of itself a mild deflation, 1% or 2% a year, is not much to worry about, probably not something a person would ordinarily notice any more than a similar level of inflation.

It is at larger magnitudes that deflation becomes a problem, pound for pound worse than inflation. Under deflation, you have a weird incentive not to spend your money, since it is worth more every day. And for reasons mostly of social convention, we have great difficulty adjusting some prices, particularly wages, downward. Both those things can be very bad for an economy.

When we talk of deflationary nightmare scenarios, we are really thinking of two examples in particular: Japan’s Lost Decade of the 1990s, and the start of America’s Great Depression in 1930-32.

As for Japan, the term deflation has become a shorthand for a bigger and more profound economic dysfunction. The deflation, per se, was not that big a problem. Indeed, contrary to popular belief, Japanese consumer prices actually went up in the 1990s. (Producer prices fell.) The argument could be made that the US is entering a similar long-term malaise, but it does not follow that deflation will necessarily be a characteristic or side-effect of it.

And it is worth pointing out that, historically, deflation has occurred in good economic times as well as bad, just as inflation has occurred in bad as well as good. The late 19th Century, for example, a period of phenomenal expansion in the US, was characterized by deflation. More recently, during the Roaring 20s, deflation averaged –1.5% per year between 1925 and 1928.

Of course it is the period just after that, when the 1920s ended, that gets all the attention. During the first three years of the 1930s, deflation averaged –8.7%, for a total drop in consumer prices of -23.8%. That did serious harm. Consumers and businesses hoarded their ever more valuable cash and employers, unable to lower wages, laid off workers or went out of business instead.

Still, even in the early 1930s it is hard to disentangle the effects of deflation itself from the effects of the economic disaster that caused the deflation. America experienced a collapse of its financial system at the start of the Great Depression that makes the start of the Great Recession seem like light comedy. Add to this a government that seemed to have a knack for doing exactly the wrong thing at the wrong time and it is no wonder that the economy ground to a halt. Deflation certainly made things worse, but if by some miracle it had not occurred I do not think the country would have been all that better off.

And just as it is hard to separate the effects of deflation from the effects of the cause of deflation, it is hard to untangle the advice given in Saturday’s two articles. Is it meant as how to deal with deflation as a stand-alone problem, or as how to deal with the economic crisis of which deflation will be one of several nasty results?

If you are thinking just of deflation itself, the advice is, or should be, pretty simple. Avoid borrowing money, because the dollars you will pay back will be more dear than the ones you get now. Conversely, lending to others, for example by investing in bonds, is a good move.

Both articles mention that bonds are a good idea under deflation and both mention that the stock of companies with little debt should be preferred. The Times even explains why.

On the other hand, the WSJ tells us to avoid financial stocks because they might suffer in an economic downturn as borrowers have difficulty paying loans back. That certainly sounds familiar. But banks are by definition net lenders that should do well from deflation. Bank stocks can often be thought of as portfolios of loans, and loans would be good to own, right? Alas, this is one of those times in which the articles are not talking about deflation but about a (further) economic downturn.

The confusion between the effects of deflation and recession are most apparent, and obscuring, when the WSJ discusses equities in general.

Deflation is generally bad news for stocks, since a period of falling prices and weak demand tends to weigh down corporate earnings and, therefore, share prices.

First off, as an empirical matter it is not so clear that deflation is generally bad news for stocks. Stocks went down in Japan in the 1990s and in the US in the early 1930s, but that’s a sample of two. Moreover, consider how perfectly reasonable the following edited version of the quote sounds.

[Inflation] is generally bad news for stocks, since a period of [rising] prices and weak demand tends to weigh down corporate earnings and, therefore, share prices.

It is true that were we to experience a deflation of, say, –5%, then we would expect, everything else equal, that stocks would go down –5%. You would certainly have been better off in bonds under that scenario. But you would not have suffered a loss in real terms. Your stocks would be worth fewer dollars only because those dollars had become worth more, not because the stocks became less valuable relative to other stuff. Your retirement kitty might seem a little smaller, but your cost of living in retirement would also seem smaller.

Taken as an abstract and stand-alone event, and I know that is hard to imagine, neither deflation or inflation should have an effect on the real value or prices of the stock market. We associate deflation/inflation with bad stock market returns because, at least recently, periods of strong deflation/inflation have been coincident with bad economic times.

Are we headed for bad economic times, as in the Japanese experience? I do not have any special insight, but I do not think so. We have had a year of mixed economic news, with much well founded anxiety grabbing the attention away from a background hum of gradually improving confidence. All of which is typical of the start of a recovery. But, for all I know, it also describes the situation in Japan around 1993.

So why two articles on deflation on the same Saturday? Couldn’t they just as well have been written months ago? Indeed, I suspect they were. The reason they both appeared when they did can be summed up in a word: August. Time to run the “evergreen” pieces from the drawer and hit the beach.


  • By Helixso, August 11, 2010 @ 6:58 pm

    Another great article! It’s times like these I wish you would put a link for a tip jar on your site. Reading this was worth the entire cost of a Saturday New York Times or Wall Street Journal.

  • By Craig, August 12, 2010 @ 9:55 am

    Solid read. The Fed has the tools and the expertise to stave off serious deflation. There were those who derided this week’s Fed announcements as weak tea, but I think it’s strong enough for this patient. I side with Brad De Long, who looks for average inflation of 0-2% over the next two or three years.

    There are times I wonder if we wouldn’t be better off with a Fed that targeted a higher inflation rate–3% or even 4%. I’m a net lender, not a net borrower, so obviously low inflation is better for _me_–I’m speaking with admirable selflessness about the macro picture, in which a dose of inflation could help to unstick wages and lift mortgages above water, facilitating the mobility of the workforce and therefore the resilience of the economy. But perhaps the Fed is wiser than I–an alcoholic can probably think of a thousand reasons why _this_ drink would be a good idea.

  • By Investor Junkie, August 12, 2010 @ 10:21 am

    Frank or anyone else can answer this question.

    Deflation and what it would look like with TIPS and the 10 year bond. Would the 10 year bond be then lower than 10 year TIPS to state deflation?

    Related to this question couldn’t the FEDs purchase of 10 years result in an artificial reading of future inflation?

  • By Michael Covington, August 12, 2010 @ 11:13 am

    Great essay. Good point about the deflationary trend in the 19th Century, which people interpreted, not as any kind of decline, but as goods and services becoming more abundant and affordable.
    Today we have been accustomed to, and adapted to, inflation for 75 years. Deflation puts the squeeze on debtors with fixed-dollar repayment obligations (such as mortgage holders and student loan holders) because the same number of dollars become harder to pay (we were counting on inflation to make them easier to pay). It also puts the squeeze on retailers, who have bought merchandise and may have to sell it for less than they paid.

  • By Michael Covington, August 12, 2010 @ 11:15 am

    Speaking of goods and services becoming more abundant, if you include computers and stereos in your measurement of the cost of living, you have to report profound deflation of those items due to technological progress. In 1960, a good stereo system could easily cost a month’s salary. Today you’re hard put to spend 3 days’ earnings on one.

  • By Steve, August 12, 2010 @ 1:17 pm

    Those in charge of the money supply have been targeting 3-to-4% inflation (as far as I know.) The Great Recession has just temporarily outstripped their ability to control it.

  • By Steve, August 12, 2010 @ 1:18 pm

    P.s. I agree with Helixso. This is my favorite blog in my feed reader. I always save it for last so I can savor the posts appropriately. :)

  • By Neil, August 12, 2010 @ 1:19 pm

    Investor Junkie – It’s a straightforward formula
    (TIPS rate over inflation) + (Expected Inflation) = (10 year bond rate)

    (Expected Inflation) = (10 year bond yield) – (TIPS rate over inflation)

    A deflation forecast would look like a 10 year yield less than the TIPS rate (currently 0.92%)

    There may be some complicating factors:
    1 – I’m not that familiar with TIPS, if there is deflation will they actually plug a negative number into the formula, or does the contract effectively have a nominal floor of 0.92%?
    2 – Inflation Protection is a form of insurance, so we’d expect TIPS sell at a premium (lower yield). So we can say the market expects a slightly lower inflation than Frank’s simple formula pumps out. How much? Dunno. But we can reasonably infer that if the market really expected deflation, the premium would be very close to zero.

  • By Craig, August 12, 2010 @ 2:45 pm


    I don’t think it’s fair to say the Fed is “targeting” 3 to 4%, because then they’d be doing everything they could to raise inflation by 2 to 3 full percentage points. I think their target range is anything above zero and below three–and the Fed is so full of inflation hawks that they’re probably happier with it below two.

  • By Mark, August 13, 2010 @ 1:43 am

    A few thoughts….

    (1) You wrote: “Bank stocks can often be thought of as portfolios of loans, and loans would be good to own [in a deflationary period], right?” This is a sophomoric statement.

    The statement disregards credit risk.

    A loan is not worth anything at all if the obligor does not have the ability to repay. Deflation, due to the impact on employment, reduces the number of obligors with the ability to repay.

    Let me follow your logic … “Collateralized debt obligations and mortgage-backed securities can be thought of as interests in portfolios of loans, and loans are good to own.” Well, no. CDOs and MBSs consisting of loans to obligors who can’t repay have gutted the global economy for close to two years now. The damage from CDOs and MBSs in a deflationary scenario would be much, much, much worse. Even though they consist of loans.

    (1) Check the recent FOMC statement. It’s not just writers at MSM outlets trying to fill inches who are thinking about this. “[C]ontext of price stability” is the buzz phrase there. This was released the day before you posted this, I think.

    The phrase “reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities” means that the Fed is “printing” money to buy debt obligations of the US. This is akin to someone lifting themselves off the ground by pulling on their belt loops. And equally sustainable.

    It’s going to be a fun ride we have in our lifetimes, I suspect.

  • By Mark, August 13, 2010 @ 2:08 am

    @Michael Covington,

    Your point re: technological advance and it’s impact on the inflation/deflation analysis is a good one. Other folks know this, and try to address it through hedonics.

    Here’s a layman’s blurb on hedonic adjustments to the CPI calcs: The article speaks to your exact point re: electronics in the first two paras.

    Hedonics are tricky, in my view, for two reasons: (1) they involve mind-bending thought experiments and (2) they’re subjective and, therefore, subject to political manipulation.

    Re: point (1), how the hell do you measure inflation, as adjusted for improvement/hedonics, for … say, wristwatches? I have a $199 dollar wrist watch, which is surely an expensive wrist watch compared to 1968 prices. BUT, it has GPS and tracks my location and speed when I jog. In 1968, while many folks humping hills in Vietnam would have LOVED a gps wrist watch, they couldn’t buy it for all the money in the world, b/c it didn’t exist. How do you measure inflation/deflation for this watch?

    Re: point (2) …. hedonic adjustments are highly subjective and, therefore, subject to manipulation and demagoguery. Health care is the best example. Things that killed you straight dead 20 years ago are now treatable and “conditions,” not “death sentences.” Amazing advances in health care. The quality of health care and outcomes is astronomically better now than just a short time ago. But, we get beat over the head with “medical costs are increasing at XXX times over CPI.” Well, they’re tweaking the CPI cost of electronics down due to better LCD screens, but I don’t think they’re doing that for better cancer treatments, amazing surgical interventions and the fact that you can shag everyone in your nursing home on prescription Viagra or Cialis.

    Just between us chickens, shagging the chick with the walker down the hall 60 years from now is a bigger QOL issue for me than screen resolution.

  • By bex, August 13, 2010 @ 12:16 pm


    “This is a sophomoric statement. The statement disregards credit risk.”

    I disagree. Frank’s general point is still valid… regardless of inflation or deflation, most people will pay back their loans. CDOs are risky investments, but stock in the banks that make CDOs is less risky.

    Sure, some of those banks went under… but as a class, a diverse portfolio of bank stock is a pretty good investment.

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