Little Air in Deflation Fears

Story Highlights:

• Deflation—reflected by recent monthly drops in the Consumer Price Index—has largely replaced inflation among today's economic concerns.
• It's not surprising price increases would slow and even slightly pull back during economic downturns. But, in our view, a severe deflationary spiral is unlikely to take hold in 2009.
• At some point, all the money from existing and planned monetary and fiscal stimulus begins sloshing around, and excess money creation's inflationary effects will begin to offset the recession's deflationary ones.
• Historical data shows mild deflation doesn't doom stocks.

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If not already, the US recession is coming soon to a store near you. Store shelves seem increasingly riddled with discounts, sales, and price cuts—concessionary attempts to ward off slowing consumer demand. After years fearing inflation, the world is shifting focus to deflation.

deflation is a near-term risk worth watching. The specter of deflation—reflected by recent monthly drops in the Consumer Price Index—has largely replaced yesteryears' threats of inflation. Deflation can be economic poison if it occurs for a protracted period—unchecked falling demand and falling prices could drive each other into a dangerous vicious cycle and trample economic activity.

It's not surprising price increases slow and even slightly pull back during economic downturns. But in our view, a severe deflationary spiral is unlikely to take hold in 2009. The Fed and global central banks have aggressively employed expansionary monetary policy to combat frozen credit markets, injecting massive amounts of liquidity into the system. The Fed has essentially doubled the US monetary base since last September, an unprecedented rate. Add that new money to the massive, newly planned global stimulus spending—the likes of which we've never seen historically—and at some point, all that money begins sloshing around, and excess money creation's inflationary effects will begin to offset the recession's deflationary ones.

Monetary policy tends to lag between implementation and effect. The monetary stimulus' inflationary effects won't be immediate. It takes time for banks to lend out the new money and for borrowers to put the money to use in the real economy. Businesses won't be able to raise prices while inventory and production levels are low, and the ensuing competition to rebuild volume will keep prices depressed for a bit longer. Once inventory and production levels get high enough, inflation can pick up quickly.

There's no doubt consumer prices will continue to soften in 2009. But neither disinflation nor mild deflation dooms stocks—during years when deflation was mild (averaged between zero and 2.4%), the S&P 500 returned an annualized 14.6%. Severe deflation would no doubt throw global markets and the economy off-kilter, but an unprecedented growing money supply and plans for more global monetary and fiscal stimulus makes such a scenario self-deflating.