Price pressure

One of the things that seems to have changed is the sensitivity of the consumer for goods and services to changes in price. While obviously, price was always a factor in making decisions about whether to buy something or not, when demand was higher, it wasn't the main factor since many consumers felt the desired product or service might get more expensive or become unavailable if they didn't make a quick decision.

As demand fell off a cliff last year and prices plummeted, consumer's have taken a different attitude, feeling that the product or service will be available and that there is stronger likelihood that it will be cheaper if they wait. This change in sentiment is clearly going to put pressure on businesses and you see things like Coach coming out with a more affordable line of product to cater to the new consumer.

This attitude is also impacting the length of time products remain in use. Where many people felt that they needed to get a new car every few years, many are now postponing that decision and driving slightly older cars. This had led to a shortage in the used car markets. Now, I sometimes see this change characterized as a switch to cheaper products, such as store brands. However, while some of that has happened, it is more accurate that consumers want the products they have been used to buying at a lower price point.

Brands that in the past tried to maintain certain price levels are being put under a lot of pressure to provide consumers with deal. Of course, we have seen how business has been able to restore profitability by cutting costs. I believe it will be quite a while before prices will go back to what they were, since consumers have learned they can demand better value for their dollar.

This is flowing down the supply chain. I hear analysts talking about the risk of inflation as the dollar declines and things like foreign oil go up in price. However, companies that try to pass increased costs through to the consumer are going to have a hard time of it. I believe they will be spurred to find cheaper alternatives or ways to reduce costs in other areas to maintain low prices.

With all the extra capacity we have, inflation is a very unlikely event for at least two years, if not longer. In fact, deflation is still a more likely scenario.

Inflation?

Now that most earnings have been reported and the better than expected earnings have caused some optimism, we will most likely spending the rest of August drifting lower in the Market.

There is a good reason for this. There are still significant issues that need to be monitored and as various groups and analysts point them out they will tend to keep money on the sidelines and induce profit taking.

We still have high unemployment and many foreclosed houses as well as underutilization of our economic capacity.

The adjustment to a smaller economy is still ongoing. During the recession the economy has contracted by about 15%. Under even the most rosy scenario, the growth rate will take years to regain that amount. In fact in the non-Government sector the contraction has been even greater.

This slack in the economy will continue to force lower prices as companies compete by being more efficient and productive and trying to grab market share. The first area of growth for most companies may very well be in exports.

One area that shouldn't be a concern for this economy is inflation. It will take many years before the demand will push prices up. Now, the value of the dollar may decline in respect to other currencies and imports may get more expensive, however, it will be very hard for these price increases to be passed on to consumers, forcing companies to continue to improve efficiency.

Bottom line is that supply and demand are the fundamental rule for pricing and we have much more supply than demand and will have it for quite some time.

Inflation - Deflation?

There are still many who predict the United States and its citizens are doomed to undergo a major depression because of the tremendous debt and the Government intervention in the free market system. Dire predictions like these have been made many times before but in times of severe economic contraction they get a lot more attention.


There are competing doom scenarios, one that predicts severe inflation and one that predicts severe deflation. Now both end up with quite dire forecasts and it sort of reminds me of a Robert Frost poem Fire and Ice.

We have been experiencing deflation recently, although it is not fully represented in the CPI. The June CPI shows an overall decrease of -1.4 year over year. A lot of this reduction is due to the change in oil prices and it would have been much worse if the Medical and Services areas didn't continue to have price increases. The oil prices from last year are clearly a short term phenomena and do distort the index. However, I think most of us feel that whatever the official statistics show, the actual cost paid for many things is significantly less than it was one or two years ago. Consumer spending is down significantly and with less demand, the price curve goes down.

Now in order to combat weak demand and potential deflation, the Fed has lowered interest rates and the Government has increased deficit spending. This takes us to the inflation scenario, one in which proponents of monetary theory believe the increase in money supply can take us no where else.

It does seem that considering supply and demand, an increase in the money supply without a corresponding increase in demand will lead to a lower price for the dollar and therefore inflation. Of course this assumes the real money supply has increased, which may be debatable considering the higher reserves held at banks and loss of wealth (i.e. money) due to the drop in housing and equities.

So would either deflation or inflation be disastrous? Depends on ones definition of disaster.

Concerning deflation, one can look at Japan which has been in a deflationary period since the mid 1990s. There was some belief that it was starting to emerge from it, but recent events call that into question. The main problem with deflation is that economic activity slows, borrowing becomes difficult as debt becomes more expensive over time and economies tend to stagnate. However, looking at Japan over the period of deflation, does not indicate that society as a whole collapsed, and the standard of living for most Japanese had been maintained at respectable levels.

As far as inflation goes, there are a number of examples of ruinous inflation, perhaps most notably the Wiemar republic. Inflation there completely devalued the Mark, led to the fall of democracy, the rise of Nazism and ultimately World War 2. Now, other countries have also had sever inflation without having a World War as a result. Inflation makes everything seem more expensive and is particularly hard on those who live on fixed incomes. It certainly makes foreign imports more expensive but makes domestic exports cheaper leading to improvements in the balance of trade. Clearly, the rate of inflation has a lot to do with the ultimate impact. If prices grow at a slow to moderate pace it is not particularly problematic. It would be sudden and rampant inflation that would cause the most disruption. The other factor, is if inflation is expected, people demand higher returns to offset the expected devaluation of the dollar, causing borrowing to get more expensive and driving down the market p/e ratios.

Now, in our current scenario, we have seen the economy contract by about 15% over the last 4 quarters. This drop in demand is what has caused the recent deflation. It seems that the stimulus and cheap money policies may be bearing fruit and demand is starting to increase. However, we know that there is significant slack in the economy related to labor and commodities that would offset any significant inflationary trends.

Now, if the dollar continues to fall internationally, it makes American products cheaper and foreign products more expensive. It is possible that increased exports can reduce the slack in domestic consumption and lead to an increase in production, potentially fueling the inflationary fires.

So what will it be? It seems that we are at the bottom of the price reductions and that as demand starts to increase we may see modest price rises. Of course, it will take awhile for these prices to return to pre-recession levels and if we make significant progress in areas such as renewable, domestic energy sources, we may find the amount of dollars going outside the country significantly reduced. We also know that Americans are saving more, and those savings are reducing the amount of money in actual circulation, just as the increased bank reserves are.

So inflation is not guaranteed. I would like to think that as the economy picks up we take an intelligent approach to deficit reduction and debt retirement. The biggest challenges there include the cost of foreign energy and health care. I am pretty optimistic about both of these and think its time we fixed them.

Deflation

Two years ago if you wanted to buy a house the amount you would have paid would certainly be higher than the price you would pay today. If you wanted to put gas in your car, you would have paid as much as $2 more than today. In most retail stores, while there were items on sale, the sales were neither as broad nor as deep as they would be today. It is also likely that the salary or starting pay you could get would be higher than you could get today, however there are a lot of variables there.

So have we experienced Deflation? One of the things that is worrisome about deflation is that since the currency is worth more, debts become more expensive. Also, since prices are declining there is a disincentive to buy since there is an expectation that whatever it is you want to buy will be cheaper tomorrow.

This may sound sort of like the situation facing us today, yet you hear a lot of talk about the return of inflation because the Government is creating money. Is it really? When the bank reserve requirements increase, you are taking money off the street. If you don't replace this money somehow, you have less money, not more. So is more money being created than has disappeared?

When you consider the idea that the Government is creating money, some seem to think they just turn on the presses and print a bunch. They actually create money by borrowing with a promise to repay. The money created this way can be considered as a "dilution" of the money supply but that is only true if the amount of money in use is greater than it was before the borrowing. It should also be noted that when banks use assets to loan money at multiples of those assets, they also either create or remove money from circulation. So is the value of those assets go down and therefore less loans can be made, there is less money. In fact, as we move more and more to electronic transactions, the need for money to ever get printed diminishes.

So, if we have had trillions of assets lost because of falling valuations in housing, stocks, inventory and commodities, isn't that a whole lot of money that went out of circulation since the banks had to reduce loans and replace the lost assets used as the basis for future loans. Has the Government borrowed enough to replace all this lost money? One problem in measuring this is that the money supply measurement that would be meaningful here includes the value of the assets on the banks books. While it looks like it has increased, that depends on whether the bank assets are properly valued. Since we dropped the "mark to market' rule it is more likely these assets are valued at hopeful amounts. This is of course why the reserve requirements have been increased, and is assets recover value, the hopeful valuations may end up being correct, but it is doubtful to me that there is really more money available.

I think worrying about inflation right now is a bit premature, we should be worried about deflation.