Deflation? What Deflation?

July 21, 1997 – When it comes to markets and making investment decisions, I don’t except anyone’s pronouncements at face value. Every statement is given a very rigorous treatment, and it is then either accepted on its merits, or rejected if the logic of the statement and/or the facts needed to support it are missing.

Recently, there has been a lot of talk about deflation. Pick up any newspaper, turn on CNBC, listen to a conversation of economic analysts – deflation seems to be on everyone’s mind. And every time I hear the word, I ask myself: Deflation? What deflation?

Because I seem to have a memory for numbers, I take note when a bottle of vitamins rises from $9.25 to $9.98. Ice cream I used to buy around six years ago at $2.79 now costs $4.89, about a 10% annual rate of increase. And I just recently went through a long and protracted lease renewal on my office – which this year had an 8.6% increase. Ouch! So I ask myself, where’s the deflation?

In order to explore this concept more thoroughly, I’ve been asking some deflationists to explain this phenomenon to me. They all seem to respond with one or more of the same pat answers.

Quoted most often are the PPI and the CPI. I don’t accept either of these government prepared indicators as an accurate measure of inflation rates (see Letter #196, Price Indices and Other Lies). But even if we accept the government’s own numbers, over the past year the CPI is up 2.3% and the PPI is flat. Even though these rates are much smaller than some of the big jumps we’ve seen in the past, the CPI by the government’s own reckoning still shows inflation, not deflation.

The deflationists also argue that there’s no pricing power left in corporate America. I think they are confusing efficiency and competition with gouging. Prices are not rising in many companies because their products are being delivered more efficiently. Many of these companies in recent years have been down-sized. Many of their products are now being produced in low wage countries. Consequently, these products are being delivered to the consumer without price increases. But this isn’t deflation.

Other forms of inflation are more insidious. I was recently speaking with a local delicatessen owner, and told him that the sandwiches he makes are getting smaller, but the price is the same. His complaint is that he is getting squeezed on taxes and rising raw material costs (i.e., the food he buys from the wholesale distributor is getting more expensive). Rather than make the sandwiches more expensive to maintain his margin, he is instead making a smaller sandwich, but selling them at the same price. Do the government’s inflation indicators measure this insidious debasement of purchasing power?

Another popular argument of the deflationists with whom I have spoken is the higher standard of living now being enjoyed.

Many of these comments are a clear and direct result of the ‘wealth effect’ from the current stock market boom – most everyone with some money in the stock market feels wealthier from the boom. And many are enjoying a higher standard of living from their stock market profits. Namely, things can be more easily afforded. These ‘wealthier’ individuals consequently ignore or overlook price rises because their income is growing faster than the rate of inflation. But that’s not deflation.

In short, despite all the hoopla, I can’t find any examples of deflation. Though many people talk about it, it just isn’t there.

So my conclusion is quite simple. There’s no deflation. But the government and anyone else who has a vested interest in making believe that the Federal Reserve is not pumping up the money supply and the economy (and therefore the stock market) has sure made most everybody believe that deflation, and not inflation is the worry today.

The last deflation in this country occurred in the 1930’s, and it had one particularly notable characteristic. Stock prices collapsed, along with the quantity of Dollars in circulation. This decline in the money supply was the cause of the deflation.

If there were deflation today, the money supply would be shrinking like it did in the 1930’s (but M3 grew by 7.1% in the latest 12-month period), and stock prices would again be collapsing like the 1930’s, instead of booming.

I think we are witnessing a popular delusion. There is a widespread mystical belief in a non-existent deflation, but this erroneous thinking can be explained. I have a unique view as to what is happening.

In the NAFTA debates Ross Perot used to talk about the “great sucking sound”. The sucking sound you hear today is of a different nature, emanating from a different source. It is coming from the stock market. The stock market is sucking up liquidity from every possible source available – from every corner of the earth. It needs to. The stock market is requiring greater and greater volumes of cold, hard cash to keep this stock bubble up in the air. Every penny of available liquidity is heading one-way – into stocks. This phenomenon goes a long way toward explaining why price rises in consumer goods, real estate, and other tangible assets have been mild, or non-existent.

The contrast to the 1970’s couldn’t be greater. Excess money was being created back then by the Federal Reserve and the nation’s banking system (they are together the monetary agents that create Dollar currency) and that excess money was going into real assets – houses, farm land, collectibles and of course, Gold.

Today excess liquidity is again being created by the Federal Reserve and the banks, but it is headed in a different direction. It isn’t going into any of the 1970’s favorites; it isn’t going into bonds. It is going straight into the stock market. There is a ‘great sucking sound’ of liquidity being gobbled up by a stock market that is requiring ever greater amounts of liquidity to keep the game alive. As a result, there is no deflation. The mild price rises at the consumer level are occurring because the excess liquidity being created by the monetary agents is going into stocks, not the prices of goods and services.

With Dollars, you never get more in the long-run, only less. For sixty years it has been the federal government’s policy to debase the Dollar. Don’t expect Bill Clinton to abandon any policy started by Franklin Roosevelt. And when it comes to deflation, don’t accept popular, but misguided, notions.