The Face of Deflation

For the past couple of years, the Fed and Wall Street have been denying the existence of deflation. Deflation is the worst economic scenario, so it is no surprise that they turn a blind eye publicly even when they are furiously working behind the scenes to prevent it and control it.

One of the ways of denying deflation is to strictly define it only as "a pervasive and constant price decline in all areas of the economy caused by a reduction in credit available or the money supply." While this is one definition, it is not the only definition.

Deflation starts out in the corporate area with a deflation of profits. It then goes to revenues and lastly causes price declines. We have already seen profit deflation and revenue deflation and some industries are experiencing price deflation.

We have also seen a reduction in available corporate credit, but not to a great degree.

The mainstream would have us believe that deflation will show up in a declining GDP and negative inflation numbers. While this is a result of deflation at its worst, it is not the only way to tell you have deflation.

Unfortunately, deflation is almost always first noticed through anecdotal evidence, not empirical data. Greenspan has testified to Congress that his office is researching deflation and what to do about it, but they don't see it yet.

The problem is that once you see deflation in the numbers it is too late to do anything about it.

Let's look at Japan. Everybody knows they have been in a deflationary funk since 1989. But does the evidence support that?

Look at Japan's GDP. It looks like it has slowed since 1989, but it doesn't look like it hasn't fallen into deflation.

But when you look a little further you see that their GDP growth rate has fallen into negative territory.

This happened years after everybody knows deflation started in Japan. So the moral is that an economy does not have to fall into recession to be deflationary.

But still, the CPI should be negative to show deflation. Again, Japan's recent history shows this is not the case. From this perspective, Japan's CPI continued upwards with only a slight slowdown in growth, again years after deflation was supposed to have started.

When you look at the annual rate of change of Japan's CPI, you see that it had been steadily declining from 1989 and finally went negative in 1994 and 1995. It then responded to Japan's attempt to re-ignite inflation for a little while and then fell back into negative territory by 1998.

To really see the deflation in Japan, you want to look at their Wholesale prices. You can see they started to dive lower in 1991. A simplistic view of declining Wholesale prices with steady CPI (see above) would be that corporate profits must have taken off, taking advantage of the lower wholesale prices. But this wasn't the case.

You can see Japan's Wholesale prices went negative years before the CPI did. They stayed negative until the attempted re-flation and then fell back again.

Now let's look at the US. Ignoring the arguments for a minute that the numbers from the Fed are bogus, let's use what we have.

You can see our GDP has also continued to climb. You can also see the little bit of a recession that hit when the growth rate went negative. The growth rate has recovered, but has the economy really? Some economists are expecting a double dip, which could prove much worse than the first.

Although the CPI dropped, it didn't go negative. You can see though that the CPI started dropping back in 1997.

Here's where you clearly see deflation in the US. In 1997 and 1998 the PPI went negative and then again in 2001. Just like in Japan, the Wholesale prices have lead the way down.

To deny deflation in the US is to deny what is right in front of you. The only question is whether the next leg down in the economy will drag the CPI into negative territory.

So far our economy is following a similar path to Japan's. But keep in mind a few major differences:

A deflationary downturn could have a much worse impact on our economy than it did on Japan's.

** All data from the Federal Reserve, format by Cornerstone

John Riley

Cornerstone Investment Services

[email protected]

16 April 2004