There's something keeping the globe's most powerful central bankers awake at night, and in spite of their best efforts, the insomnia could get worse. What nightmare is on their collective minds? Deflation, which is the exact opposite of their old nemesis, inflation. It's a global economic nightmare that is starting to look like a reality.
Recent earnings from companies spanning the market's biggest sectors—Procter & Gamble, Caterpillar, Microsoft, JPMorgan, UPS, Pfizer and United Technologies—all disappointed investors. Now each company has given its own unique reasons for the misses, but when it happens in so many sectors, it is hard to dismiss these weak results as isolated events. And there's macro evidence that the misses aren't by coincidence: Slowing expansion in U.S. factory activity and negative durable goods orders, based on the most recent stats, unfortunately match up pretty well with the lousy earnings reports.
At the heart of all this is weakening pricing power, and that's just another way of describing deflation. And that anti-austerity Greek election that looks to bring back that pesky European debt crisis? Not helping.
Most of us have been enjoying the lower prices at the pump, printed on our utilities bills and featured in other common household goods and services; even lower interest payments. This is apparent in the surging U.S. consumer confidence data, but the recent results expose the flip side of the equation: Falling prices can be too much of a good thing. That's the way central bankers see it. In fact, they're freaked out by it. And if it's got the central bankers in a tizzy, there's a good chance it's going to affect you.
A primer on the global spending psyche
Let me explain how this occurs, because it may seem somewhat counterintuitive.
Inflation is when consumers and businesses expect the prices of goods and services to rise over the near and intermediate term, and that has an effect on spending behavior. Consumers and businesses are more likely to buy what they need and want sooner rather than later because they are confident that if they wait, they'll have to spend even more money on the same exact things in the near future. When they spend money at a faster rate, it causes prices to rise even faster, a self-fulfilling prophecy of increasing prices.
On the converse side, deflation is when consumers and businesses expect prices of their goods and services to fall over the near and intermediate term. As a result, this has the exact opposite effect on spending behavior: They are more likely to delay their purchases. When this happens, it becomes a self-reinforcing cycle of delayed purchases, which means less demand, which then means lower prices. If this becomes ingrained in the psyche of consumers and businesses, the world is facing a deflationary spiral.
"Like that old expression says, Consumers may be 'whistling past the graveyard.' Or to quote a contemporary source, as Taylor Swift said, consumers may be unaware that deflation is a 'nightmare dressed like a daydream.'"
OK, so what's the problem with having lower prices?
There is no problem, as long as consumers and businesses don't start thinking of falling prices as a long-term trend. How far can the deflationary psyche extend? Think of it this way: If prices for things you purchase are lower, it means your county will collect less sales tax. If incomes are lower, not only does the government collect less in income taxes, but people start to drop into lower income-tax brackets, pushing income-tax revenues even lower.
I'm all for lower taxes, but the point here is that lower prices cause lower tax revenues, which means that local governments and debtor nations (the entire developed world) will have a harder time servicing their debts. If a central government loses the ability to borrow, you can safely bet that its resident businesses and consumers will lose their ability to borrow as well. The last thing we need is another sovereign debt crisis, which was caused by worries over nations potentially missing debt payments and going into default (remember the "PIIGS"? Portugal, Italy, Ireland, Greece and Spain).
This is why the Fed and the ECB have inflation targets of 2 percent. It is just enough to maintain a little revenue growth, allowing debtors to mildly inflate their way out of debt and to keep the GDP humming along without running too hot or too cold.
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And if a company's products are selling for lower prices, it means that it is going to have lower or flat revenue. I mean, have you noticed that companies have had a difficult time growing revenue over the last six years? This means they need to keep cutting costs, and it's the same for municipal and national governments. Cutting costs, which in turn causes even more price destruction, which leads to low wage growth, which leads to lower GDP, which leads to less revenue, which leads to swelling layoffs, which leads to even lower prices, which leads to recessions and so on, is a vicious cycle.
So while consumers enjoy lower prices, central bankers are worried that the negative effects of deflation will eventually catch up to them. Like that old expression says, Consumers may be "whistling past the graveyard." Or to quote a contemporary source, as Taylor Swift said, Consumers may be unaware that deflation is a nightmare "dressed like a daydream."
To fight off deflation and to stimulate demand for products and services, the central banks (the Federal Reserve), BOJ (Bank of Japan), the BOE (Bank of England) and now the ECB (European Central Bank) have embarked on massive money-printing schemes called QE, or quantitative easing. The goal is for this money to make its way through the lending and borrowing mechanisms of their banking systems and ultimately into their economies.
But another goal of QE is to devalue the respective currency, which means it should take more units of currency to purchase the usual goods and services. Prices will go up with an increase in the supply of currency and lead to the "Better buy now or you'll have to spend even more money later" psyche. That's why the central banks are trying to make consumers collectively believe inflation is at hand and that they need to spend money now before their money is worth less in the near term. Inflation pulls demand forward.
Unfortunately, there is scant evidence that QE is actually achieving its goal; inflation is very low or nearly flat throughout the global economy. I watched the live broadcast of the ECB announcement (January 22), in which its president, Mario Draghi, delivered the details of the newest QE, despite the lack of evidence for existing QE programs delivering on their inflationary goal.
The fact of the matter is that not only is inflation subdued in the euro zone, it went negative at the end of 2014. Draghi cited that as a key reason for initiating the new European QE. His goal is to push inflation up to a level slightly below the ECB's 2 percent target. The specter of a "Grexit," with Greece deciding it will abandon the euro as its currency, only takes away some of the punch from the European QE, though the last thing we need is another reason to have even less confidence in the ECB.
The reason behind the subdued inflation is as man-made as the QE medicine: too much capacity in virtually everything that is made and mined.
If Apple received orders for an additional 5 million iPhones tomorrow, would the company have any trouble filling the orders? If China ordered an additional 1,000 tons of copper and aluminum, would Australia or Peru have any trouble digging up more metal? If the world needed an additional 250,000 barrels of crude per day, would producers be constrained? No, no and no. I could use the same reference for corn, wheat, semiconductor chips, automobiles, TVs and even labor.
The only supply constraint that is easily identifiable is the lack of supply constraints. This is why prices are falling faster than QE money printing can dilute and devalue local currencies. Eventually, free market forces will act to balance supply and demand, a process made less painful by increasing demand as opposed to decreasing supply.
I am not trying to paint a picture of doom and gloom, but rather highlight why the actions of the current era's central bankers are decisions that touch every consumer and business. The good news is that deflationary periods are the exception, not the rule. In the U.S., economic stats show increase loan demand, employment growth, a banking system that is extraordinarily well capitalized, refinancing debt that has brought down costs, and low energy prices that are a stimulant for the U.S. and its trading partners. GDP is trending above 3 percent, consumer confidence is high, and the housing sector, while not booming, continues to improve.
That keeps me bullish, but I'd be even more bullish if Europe, Japan and our other trading partners showed improvement, too. QE, in my opinion, bought us time to deal with the financial crisis and its aftershocks. Whether or not it nudges inflation higher remains to be seen, but for now, investors are willing to believe in its potential benefits. Deflation, or the D word, as it is now being referenced, is the topic of the day in global finance and the biggest risk to nearly all economic participants, and that includes yourself.