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Wednesday, February 12, 2014 2:43 PM

Deflation Theory Reality Check: Why Inflation is Severely Understated; Feel Good Effect

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If you repeat something completely inane enough times, do people, even economic writers, believe it?

To understand the context of my question, please consider the Bloomberg article Price Slowdown for Cars, Baby Clothes Raises Fed Concerns by Michelle Jamrisko and Ilan Kolet.

Five years into the U.S. economic expansion, inflation shows little sign of picking up as prices rise more slowly for goods and services from automobiles to medical care, complicating the Federal Reserve’s drive to guide the economy away from the precipice of deflation.

The personal consumption expenditures price index, minus food and energy costs, rose 1.2 percent in 2013, matching 2009 as the smallest gain since 1955. Of 27 categories of goods and services in the gauge, 18 showed smaller price increases over the past two years, according to data compiled by Bloomberg.

The slowdown has been broad-based, with durable goods such as autos, nondurables like clothing and services including health care all playing a role. Fed policy makers are on guard to keep such disinflation from morphing into outright deflation, a persistent drop in prices that prompts households to delay purchases in anticipation of even lower costs and leads companies to postpone investment and hiring.
Emphasis in red is mine.

Deflation Definition

In the following discussion, except where prefixed, the term "deflation" means a drop in consumer prices (even though that is a miserable definition).

I use that definition for point-of-discussion purposes only, simply to show the ridiculous nature of widely held beliefs.  

Deflation Theory

"A persistent drop in prices prompts households to delay purchases in anticipation of even lower costs" say the authors of the above article.

I have heard that theory expressed hundreds, if not thousands of times. I suggest a reality check.

Reality Check Questions

  1. If price of food drops will people stop eating?
  2. If the price of gasoline drops will people stop driving?
  3. If price of airline tickets drop will people stop flying?
  4. If the handle on your frying pan falls off or your blow-dryer breaks, will you delay making another purchase because you can get it cheaper next month?
  5. If computers, printers, TVs, and other electronic devices will be cheaper next year, then cheaper again the following year, will people delay purchasing electronic devices as long as prices decline?
  6. If your coat is worn out, are you inclined to wait another year if there are discounts now, but you expect even bigger discounts a year from now?
  7. Will people delay medical expenses if prices drop?
  8. If your child has a birthday next week, will you hold off buying him a present because the price of toys will be cheaper next month?
  9. If your lease is up and you have to move, can you wait six months in anticipation of better prices? Two months? One Month?
  10. If deflation theory is accurate, why are there huge lines at stores when prices drop the most?

Bonus Question

Other than meaningless examples like waiting a few days for known sales, can anyone come up with any consumer item that people will delay purchasing simply because prices are falling? 

Opposite View

Except in cases of extreme inflation or hyperinflation, I take the opposite view.

I propose people will delay purchases if prices are too high and/or they think they cannot afford something.

Take the worn-out coat as an example. If prices are too high, some will consider making that coat last another year.  Perhaps they get the coat, but not the hat they also wanted.

Unless wages keep up, people can only spend what they make or what they can get credit for.

Where's the Evidence?
I cannot come up with a single consumer item that people will routinely delay purchasing simply because prices are falling. Can you?

Is there any hard evidence that shows people significantly delay purchases (other than asset purchases) when prices fall? (Please don't respond with insignificant delays ahead of pre-announced sales or year-end car clearances).

Even if people did delay consumer purchases (which they don't), why would it matter? Can People delay forever?

Asset Prices

Asset prices, especially financial assets and real property, are another story.

People, especially those in debt, will indeed delay purchasing real estate if they expect better prices next year. History also shows people are reluctant to buy stocks and bonds if they fear lower prices.

Both of those are significant, but neither is represented in the CPI.

Corollary: People like bull markets in equities and bonds no matter how ridiculous the price.

PEs to Consider

Amazon: AMZN : The PE of Amazon is 592, Valuation is $160 Billion
Linked In: LNKD : PE of Linked In is 837, Valuation is $23 Billion
Facebook : FB: Facebook PE is 106, Valuation is $165  Billion
Priceline : PCLN : PE of Priceline is 36, Valuation is $64 Billion
Hertz : HTZ: PE of Hertz is 37, Valuation is $12 Billion
Starbucks : SBUX : PE of Starbucks is 483, Valuation is $57 Billion 
Boston Beer (Samuel Adams) : SAM : PE of Boston Beer is 43, Valuation is $3 Billion

I could go on and on but I won't.

At current earnings, investors in Amazon will have to wait 592 years for a positive return on earnings. More realistically, they would have to wait forever because Amazon does not pay a dividend.

In the above list, the only company that pays a dividend is Starbucks, and it is a paltry 1%.

The only thing those companies have going for them is investors are willing to bid up asset prices to preposterous heights.

Why Inflation is Severely Understated

Krugman and others lord it all over those who predicted massive price inflation. I did too, and still do!

Along with Krugman, I laugh at those expecting a huge outbreak of "price inflation". Unlike Krugman, I understand what is going on.

The fact is, we currently have massive inflation. However, instead of inflation being visible in the form of higher consumer prices, inflation is visible in the form of asset price bubbles.

To see inflation, all you have to do is open your eyes and look at lofty valuations of stocks and bonds.

Deflation Coming Up

Don't hold your breath waiting for a surge in "inflation". We already had it. Instead, expect various equity and corporate bond bubbles to implode.

With the busting of various bubbles, asset prices will drop, and so will credit marked-to-market on any loans banks made on those asset bubble.  So rather than expecting a huge surge in inflation, I expect deflation in terms of credit and prices.

Misguided Fed Policy

In an absurd attempt to prevent price deflation on consumer goods, the Fed has spawned asset bubble after asset bubble, each with a greater amplitude.

Given exceptionally poor jobs and wage growth, the very thing consumers need to survive is falling prices!

Yet, the Fed tries to prevent just that, all based on the idiotic premise "A persistent drop in prices prompts households to delay purchases in anticipation of even lower costs".

Feel Good Effect

Bubbles make people feel wealthy, and that exuberance spawns all sorts of poor economic decisions about what people can afford.

When asset bubbles collapse (as they always do), that's when people finally realize they spent too much and pull in their shopping horns. 

Those expecting a huge pickup in price inflation, a spike in US GDP, or a big boom in housing, all based on misguided perceptions of "pent-up housing demand" or equally misguided theories about "excess reserves", fail to understand how Fed boom-bust and bank-bailout policies preclude such outcomes.

Further Deflation Discussion

For further deflation discussion please see ...


The Fed's attempt to spur inflation in a deflationary world causes the very thing the Fed fears most (an economic slowdown caused by a collapse in asset prices). In turn, a collapse in the valuation of assets causes bank losses and reduces desirability and even ability of banks to lend.

The Fed is fighting the wrong battle. It's a collapse in asset prices (not consumer prices) that will restrict bank lending and cause consumers to hold off on consumer purchases.

The only correct approach is to not spawn bubbles in the first place. (Please see Bubblicious Questions: What Causes Economic Bubbles? When Do Bubbles Burst? Can the Fed Prevent Bubbles?)

Return of Deflation
The current "feel-good" effect will not last forever, look out below when it wears off. Deflation, in terms of consumer prices, asset prices, and credit will return.

Misguided Fed policy ensures that outcome.

Mike "Mish" Shedlock

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