You Can Lead A Horse To Water...

In his Adviser Soapbox on Forbes, entitled Deflation Descends Upon the U.S., Gary Shilling describes how falling goods prices are self-perpetuating, how they make the burden of debt repayment harder, and how this process will prolong the economy's misery.

For years, we've been forecasting that chronic deflation of 1% to 2% per year would start with the next major global recession. Well, it's here!

In October, the U.S. producer price index fell 2.8% from September, and the consumer price index dropped 1%, the biggest decline since before World War II. Sure, the big driver was the decline in energy costs, but even excluding food and energy, consumer prices dropped 0.1%. As retailers panic in the face of retrenching consumers, prices of many items have nosedived.

Dell is offering 20% to 30% discounts on new notebooks. Nearly empty Hawaiian hotels give free drinks and all sorts of discounts. Retailers like Crate & Barrel have gained pricing power over vendors and are getting 10% to 25% lower prices to pass on to customers. Kohl's is discounting Christmas merchandise up to 75% to attract shoppers. Toys are being discounted 50% to 60%, and sellers are emphasizing low-priced merchandise to attract frugal buyers. Just look at Wal-Mart.

Grocers are also gaining pricing power over suppliers of branded goods, as consumer zeal for house brands gives retailers more leverage with producers of national labels. Upscale retailers are unloading excess inventory on discounters who then offer designer apparel for 45% to 70% off list prices. And luxury goods makers themselves are slashing prices on apparel, shoes and handbags sold in the U.S. Of course, the strong dollar makes that easy for eurozone-based firms. Don't forget that recent auctions were disappointing and saw prices of contemporary, modern and impressionist art drop 30%.

The Fed worries that in deflation, offsetting monetary policy is difficult since its target rate has to stop declining when it reaches zero. Of course, the Fed has other tools, like quantitative easing (juicing the money supply). Nevertheless, all these measures amount to leading the horse to water, but he may not drink.

The deflation in Japan in the 1999-2005 years worried the Fed when it appeared imminent in the U.S. early in this decade, and it still does. Japan again faces chronic deflation, and the Bank of Japan forecast zero change in the CPI (excluding food but not energy) for the fiscal year ending March 2010. Fed Vice Chairman Donald Kohn said the lesson from Japan was that "we should be very aggressive in combating deflation."

Deflation encourages saving, since money is worth more in the future than it is today. It also spawns deflationary expectations. Buyers anticipate lower prices later by waiting to buy. That sires excess inventories and capacity, which forces prices down. Buyer suspicions are confirmed so they wait even further to buy, generating a self-feeding downward price spiral, as now seen in autos and houses.

Deflation also elevates the cost of debts and debt service since both remain fixed in nominal terms but the revenues and incomes used to repay them tend to fall with overall prices. Deflation fears and other forces have also reduced reducing 30-year Treasury bond yields to our long-held target of 3% and completed what we dubbed in 1981, when the yield was 14.7%, "the bond rally of a lifetime." The recent financial crisis has also helped as investors abandon everything else, stocks and fixed income alike, in favor of Treasuries.

Deflation results from overall supply exceeding general demand. We have been forecasting the good deflation of excess supply, as in the late 1800s and in the 1920s, due to today's confluence of semiconductors, the Internet, computers, biotech, telecom and other productivity-soaked technologies. But we have allowed for the bad deflation of deficient demand, as in the 1930s, if one of two adverse conditions develops: widespread financial crises and worldwide protectionism. Sadly, both are real possibilities.

Inflation? Many, of course, worry not about deflation but inflation, due to all the money being pumped out by central banks and governments globally. They, no doubt, are biased since most have lived only in an era of inflation and don't agree with us that inflation is the result of excess government spending in wars, both hot and cold. In peacetime, deflation reigns. Starting with rearmament in the late 1930s, then World War II and the Cold War with its hot phases, Korea and Vietnam--wartime and inflation persisted for 60 years. For now, at least, all that money from central banks and governments isn't getting beyond the financial institutions it's meant to buoy.

We're in a liquidity trap. The horse isn't drinking, thank you very much. And if lenders do start to lend, central bankers, with their congenital fear of inflation, will no doubt reel in all that extra credit. Even if the bank reserves stimulate the money supply with the usual multiplier effect, the credit created will pale in comparison to the destruction of derivatives and other privately created liquidity due to persistent de-leveraging and write-downs.

Finally, the consumer saving spree we're forecasting will probably increase the saving rate by one percentage point per year on average for the next decade. That would generate a cumulative $5.5 trillion in savings (read "not spending") and go a long way to offsetting the intervening fiscal stimuli, and then some.