Last week’s economic data is underestimating deflation. On Wednesday the Bureau of Labor Statistics (“BLS”) announced that the consumer price index (“CPI”) declined by 1.0% in October which was the biggest single one month reported decline since before World War II. Broad based deflation exacerbates the already severe credit crisis and increases cash hoarding by households and businesses. However, CPI deflation estimates are wrong because deflation is much worse than reported and the United States has already entered into a deflationary death spiral.
Unfortunately, many economists are looking at the flawed historical and current CPI data to conclude that deflation isn’t a clear and present danger. Fed officials also don’t seem to understand the threat. In a disturbing denial of reality, on the same day as CPI reported broad based deflation, Fed Vice Chairman Donald Kohn said that the risk of sustained and broadly falling prices was slight.
Deflation destroys corporate profits and is like pouring hydrochloric acid on bank loan portfolios because borrowers have less cash and assets to pay back lenders. Obviously, corporate borrowers that can’t service their debts because of deflation aren’t a very good stock investment. A real life lesson in how deflation affects borrowers, lenders and investors is the fall in home prices and the destruction to national wealth that occurred as a result. There are no winners in the current residential real estate price crash as families lose their life savings, lenders fail and 401(k)‘s and other investments crash.
Deflation is here and is probably worse than the official statistics indicate for the following reasons.
- BLS is overestimating the price level for housing which makes up approximately 42.4% of CPI.
Curiously BLS is reporting that housing costs went up 3.2% from October, 2007, to October, 2008. It isn’t clear whose house went up in value or how housing costs could have possible increased. But somewhere in the alternate universe of BLS statistics it must have happened and CPI is signaling housing inflation. Specifically, CPI data includes an increase of 2.3% in the cost of homeownership (through an obscure definition of the cost of owning a house excluding utilities, furniture, heating and other operating expenses), 3.7% increase in rent and a 2.0% increase in the cost of furnishings. Somehow CPI has missed the residential real estate crisis and as a result is grossly underestimating deflation.
- BLS is overestimating the cost of new and used cars which make up approximately 7.2% of CPI.
Statisticians from BLS probably only take mass transit because they can’t have been in a car dealership lately. BLS is ignoring that automobile prices are collapsing. BLS estimated that the drop in new and used motor vehicles was 2.3% from October, 2007, to October, 2008, which while in the right direction, is still very wrong by a large magnitude. Reading any local paper that runs automobile advertising quickly validates double digit declines in vehicle prices.
- BLS is overestimating apparel prices which make up 3.7% of CPI.
BLS is estimating that apparel prices actually increased 0.3% from October, 2007, to October, 2008 which I find shocking. First Capital finances scores of apparel manufacturers and over the last 12 months the prices that retailers are paying for goods from our clients has dropped. And, wholesale price declines are being passed on to consumers. As an example, last week my wife purchased clothing for our 11 year old daughter. They went to Macy’s and purchased 2 pairs of jeans, a shirt with legging and a shirt with a scarf. The total cost for the 4 garments, including tax, was $21.57. The price tags on my daughter’s clothing indicated an original retail price, including tax, of $71.57 which means that the merchandise was discounted by approximately 70%. Recently, my wife and I purchased men’s printed tee shirts for our 15 year old son and paid $1.99 per tee shirt. And, last month I purchased pants for myself and paid less than $20 a pair. 12 months ago the same pants were selling for $45. BLS hasn’t noticed that apparel retailers are going bankrupt by the dozens and one of the reasons for the retailing collapse is that prices are rapidly falling.
While on the surface falling prices seems to help consumers pay their bills, that analysis only works if consumers also don’t need jobs. Deflation has a quick corrosive effect on the viability of employers because they purchase goods at one price and then because of deflation have to sell their inventory at a loss. While a lot of inflation feels like an economic flu, deflation is like “cardiac arrest” for business.
Without realistic and reliable economic statistics policy makers cannot do their jobs. Moreover, until government economists get “real” about where the economy is, and where it is going, they will continue to destroy confidence with inconsistent and reactive policy solutions.
Since deflation is both real and more severe than being reported, fiscal and monetary policy options need to be re-examined through the sharp lens of a “wage price death spiral.” The longer government fails to respond to deflation the worse the economy is going to get.
Since the week ending September 22nd seasonally adjusted M2 hasn’t changed very much. During the same period the Federal Reserve’s balance sheet grew from approximately $1.1 trillion to $2.2 trillion. I think that M2’s failure to grow indicates a type of cash hoarding in accounts that would have been picked up in M3 (if the Federal Reserve still published the statistic) which is consistent with deflation.
During the 1970’s President Ford started the WIN campaign, i.e., Whip Inflation Now, as he used the Presidential bully pulpit to try to jaw bone inflation down. On inauguration day President Elect Obama needs to start the DDT campaign, i.e., Defeat Deflation Today. But he needs to use more than the bully pulpit to defeat deflation, massive emergency fiscal stimulus is needed to shock the economy back to into its natural rhythm before it is too late.