Deflation: Friend or Foe?

Doug Marshall
Market Assessment
December 5, 2008

It’s hard to keep up with the news in this market. Not more than a couple of months ago, we were all worried about runaway inflation with oil prices leading the way. What a difference a few months make.

Now, the worry is deflation. Deflation is a period of falling overall prices. Prices can drop in order to reflect an adjustment in the market. It’s perfectly natural at times, and wonderful. However, if prices drop for extended periods of time, it hurts the economy rather than helps.

Here’s an example: you are in the market to buy a new home, but do you want to be the person who takes out a mortgage on a home that may likely be worth less in six months? Assume for moment that you want to put 10% down and finance the balance. If the price of the house you purchased continues to fall what happens to your equity? It eventually goes to zero and at some point the loan balance may exceed the value of your home.

So instead of buying a home, you wait. Consumers and investors delay buying since they expect further price drops.

Banks, borrowers, and businesses all stand to lose from such a situation, causing more economic turmoil for the average citizen as well as the capital markets. During the Great Depression, 10% deflation per year contributed to a huge lack of demand. Farmers found it impossible, also, to keep up with mortgage payments, due to the falling prices of agricultural products. (1)

How real is this worry? Here are some statistics from October alone that have economists’ brows furrowed (2):

> The consumer price index dropped an unexpectedly large 1%, including an 8.6% plunge in energy prices. The core index (excluding energy and food) fell 0.1%, the first drop in the index since 1982.
> The producer price index, measuring wholesale prices, reports that the index fell 2.8% in October, including 12.8% in energy prices. This is the largest decline in the PPI in the report’s 61-year history.

Another example of deflation of most concern to the real estate profession is the yields on treasuries. Yields have fallen on the 2-, 10-, and 30-year bonds to some of the lowest levels since the Federal Reserve began keeping records in 1962.

This is a sign of frozen credit (3), where lenders would rather invest in low yielding treasury bonds rather than lending to other lending institutions or borrowers where the risk of default is unknown.

All in all, a deflationary period of any sustained length of time would hurt everyone. Let’s just hope that the market proves more resilient than to follow this inevitable path to destruction.

1 John W. Schoen, “Falling Prices Raise Worries About Deflation” (MSNBC.com Eye On The Economy)
2 Ben Steverman, “Deflation: What Investors Need To Know” (BusinessWeek)
3 David Goldman, “Treasurys: The Pressure Eases A Little” (CNNMoney.com)