Investors brace for risk of deflation

Investors are constantly reminded to think about inflation when making decisions about their money.

Now there’s a new wrinkle: the possibility of deflation.

We’ve already had severe deflation -- falling prices -- in housing, stocks and commodities this year.

The question is whether that could spill into prices of goods and services across the board, as well as into wages, as the economy worsens.

If you knew a serious deflation was coming, there are at least a few things you’d want to do with your portfolio and your finances.

On the assumption that interest rates would continue to fall, you’d want to lock in yields on high-quality bonds or bank savings certificates.

You’d also want to avoid borrowing, because debt becomes more onerous in a deflationary world.

And in the stock market, you’d want to stay away from shares of companies that have high debt loads or that have little or no pricing power with their products or services.

Hmm . . . all of that sounds like what a lot of investors already have been doing, doesn’t it?

Most economists, however, don’t buy the idea that the U.S. could fall into an extended period of actual deflation. That conjures images of the Great Depression, or Japan from 1995 to 2005.

Although the U.S. is surely headed for a painful recession, there still is a widely held view that we’re not on the verge of economic calamity -- despite the dive in financial markets.

On Friday, the government reported that its employment cost index, which measures the growth of wages and benefits in the economy, was up 2.9% in the third quarter from a year earlier.

That’s seeing the economy in the rear-view mirror, to be sure, but it shows that incomes were holding up.

If you use the consumer price index as a benchmark, it shows that inflation overall has been easing in recent months but remains at the highest level in many years.

The CPI in September was unchanged from August, after seasonal adjustment. And compared with a year ago the index was 4.9% higher -- mainly because of the surge in energy prices that began last fall.

But it’s virtually certain that inflation will be coming down over the next six to 12 months, for two reasons.

First, we all know what has happened with oil prices. Crude has fallen by more than half from its July peak, to $67.81 a barrel now. Prices of other commodities also have slid.

The decline in energy costs alone will put downward pressure on the CPI each month compared with a year earlier.

Second, recessions naturally suppress inflation because companies have less pricing power as demand for their goods and services wanes.

“Companies can’t raise prices so they force prices down at their suppliers,” notes economist Maria Fiorini Ramirez at MFR Inc. in New York.

As that trend cycles through the economy, she expects the CPI to rise just 2.1% in 2009, down from 4.1% this year.

Declining inflation is good for the economy, and consumers, in the long run. And in some businesses, such as tech, prices are always falling.

But if the CPI were to go negative for an extended period, that would signal that a potentially dangerous deflation had kicked in. It would suggest that demand was so weak that companies were slashing prices to a level that would gut their earnings, in turn fueling massive layoffs and wage cuts.

Could it happen?

Tom Higgins, chief economist at investment firm Payden & Rygel in L.A., isn’t predicting a drop in the CPI in 2009.

But he believes the risk of outright deflation is higher today than it was in 2002-03, the last time there was serious talk about a broad-based decline in prices taking hold.

Because the double whammy of falling home values and plummeting stock prices over the last year has sharply eroded many people’s net worth, “I’d be much more worried about deflation today than in 2003,” Higgins said.

The fear is that consumer spending, which already is contracting, could collapse -- doing the same to prices.

And as prices fall, even people who have spending power would be inclined to close their wallets and wait for things to get even cheaper.

“Deflation begets deflation because people defer purchases,” said Peter Kretzmer, senior economist at Bank of America in New York.

That was Japan’s miserable situation from the mid-1990s until just a few years ago.

The Japanese experience is what spooked the Federal Reserve in 2002, when the CPI was rising at a mere 1.1% annual rate as the economy struggled to emerge from recession.

Policymakers used code in publicly discussing the chances of deflation back then, referring to the risk of “an unwelcome substantial fall in inflation.”

Even as the economy expanded, the Fed held its benchmark short-term interest rate at 1.75% for most of 2002, then hacked it to 1.25% later that year, and finally to a 45-year low of 1% by mid-2003.

It’s no coincidence that we’re back to 1% on that rate now, with the Fed’s half-point cut on Wednesday.

Rock-bottom rates obviously are aimed at easing the credit crisis, but the Fed also is hoping that low rates eventually will underpin a pickup in consumer spending (if credit becomes available again), forestalling deflation.

Some analysts, however, believe deflation is inevitable in 2009. Nouriel Roubini, head of Roubini Global Economics in New York, accurately predicted the credit crisis and the devastating turmoil in financial markets. Now, he foresees a severe-enough drop in consumer demand that deflation will become “the main concern” of the Fed by spring.

Roubini points to the narrow difference in current yields on Treasury Inflation-Protected Securities, which guarantee against rising inflation, and yields on conventional Treasuries. That small difference shows that investors expect little inflation in the years ahead, or actual deflation.

For investors, the risk of a deflation scare implies more danger ahead for the stock market in 2009. It also suggests that high-quality bonds (particularly conventional Treasuries) will remain a favorite refuge, and would become even more appealing if yields were to rise as the government issues more debt to fund the financial-system bailout.

As for cash accounts such as money market funds, the Fed’s efforts to pull down short-term rates mean cash will earn less. But there’s an offset: In a deflationary environment, cash becomes worth more every day.

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tom.petruno@latimes.com