Global deflation risk grows

October saw one of only seven monthly drops in the core Consumer Price Index since 1947.

Global concern about inflation, which was widespread just a few months ago, has given way to worries about an opposite and potentially more dangerous problem: deflation.

In the United States, the Consumer Price Index (CPI) took a rare nose dive, plunging by 1 percent in October, the Labor Department said Wednesday. That's the largest fall in a single month since 1938.

Much of the price decline so far is concentrated in energy, and most economists aren't forecasting that 2009 will see the kind of broad and persistent price declines that helped make the Great Depression so severe.

Still, a wider downdraft in prices is possible, and if unchecked it could restrain consumer and business spending and make it harder for the economy to recover from a global slump. That's one reason central bankers and finance ministers are acting to ease interest rates, prop up banks, and ramp up government spending as a stimulus.

"A deflationary depression is a very real possibility," says Ed Yardeni, an economist who heads Yardeni Research in Great Neck, N.Y. "We're now experiencing a dangerous negative feedback loop between the problems in the credit system and a downturn in the economy. The policymakers around the world are attempting to break that vicious cycle."

In the October report, consumer prices fell slightly in the so-called core index that strips out food and energy – a sign that price weakness extends beyond real estate and the gas pump. The core index has declined in only six other months since 1947.

The 0.1 percent month-over-month drop in the core price level surprised forecasters. The trend is probably continuing this month, as struggling retailers slash prices going into the holiday sales season.

The overall index generally moves up rather than down, and rarely changes by more than a percentage point in one month.

Falling prices, by forcing businesses to either cut costs or accept lower profits, could make things tougher in both the job market and the stock market. US stock indexes dipped lower Wednesday morning after the consumer price index (CPI) report.

In the adverse feedback loop, the worse the economy gets, the more banks are battered by loan defaults and the falling value of collateral. In turn, credit becomes less available, restraining consumer and business activity – slowing the economy further.

A tightening of credit conditions is typical of most recessions, as are price declines for commodities like oil.

But in a bleak scenario, seen in America in the 1930s and in Japan in the 1990s, falling prices add another element to the feedback problem. Back in the Depression era, economist Irving Fisher coined the phrase "debt deflation," to refer to a period when many debtors are trying to reduce their liabilities, or leverage. When borrowers are de-leveraging all at once, prices for assets such as homes or stocks can fall below what would ordinarily be their fair value.

Moreover, if deflation becomes a broad-based trend that consumers expect to see in everyday goods, they may delay purchases in the hope of getting an even better price later. Similarly, life becomes harder for borrowers – whether it's a family buying a home or a business building a factory. The burden of the debt effectively grows larger over time, since the amount owed is not adjusting downward like other prices.

"Deflation, like runaway inflation, can be self-perpetuating insofar as consumers defer expenditures," David Rosenberg, Merrill Lynch's chief US economist, warned in a report to clients last month. "The pricing backdrop is 'deflationary' today even though consumer prices have yet to deflate on a year-over-year basis."

He pointed to several ways in which deflation is now at work – some of them not in consumer prices but in forces that may affect those prices:

•Asset values are deflating, with US home values down 16 percent in a year and stock shares down about 40 percent – for a combined loss of $11 trillion in wealth. (In the CPI, the cost of shelter is computed using a "rental equivalent" formula that ignores the ups and downs of home prices.)

•After years of households building up heavy debts, the volume of consumer credit is declining significantly for the first time since the early 1990s.

•The job market is symbolically a "deflating" force, with fewer jobs translating into less income for consumers.

Such trends, economists say, means that inflation has ceased to be much of a near-term concern, despite the extraordinary interest-rate cuts and special lending provisions by the Federal Reserve and other central banks.

The current risk of deflation could be amplified by the global nature of the current crisis, which now encompasses many nations. Global commodity prices have been falling fast.

For all the comparisons to the 1930s, the current cycle hasn't approached anything like the Depression, when prices plunged for several years.

Mr. Rosenberg forecasts that modest year-over-year declines in US prices will be visible for much of 2009.

Many economists expect that inflation will be minimal but won't turn negative for 2009 as a whole.

"We believe that this inflation plunge will be temporary, and inflation will make a comeback as soon as 2010," economists at Morgan Stanley wrote last week. Still, they warned of the near-term risk that policies to counter a recession "may not find traction as early or by as much as we think."