July 26, 2006

Managing Deflation Expectations

The "mother of all deflations" may be quickly approaching as the nation's housing market loses steam at a quickening pace. Despite talk of a soft landing from real estate professionals and economists, observers are well advised to stand clear as touch-down approaches.

Indeed, if present trends continue, the nation's number one economist, Fed Chairman Ben Bernanke, may be well advised to begin work at managing "deflation" expectations, rather than obsessing over whether the core rate of "inflation" is a quarter point too high.

Given the current slope of the blue line below, and its unlikely flattening at a rate of change that all economists love - two percent - there are potentially much bigger problems ahead than whether poll respondents believe gasoline prices will rise further in the year ahead.

All the recent talk about "inflation", as measured by the various consumer price indexes, has distracted many from the most important 'flation of them all - housing.

While the rise and fall of home prices may not be deemed worthy of the inflation and deflation monikers at the Bureau of Labor Statistics, that doesn't mean that they aren't important.

And, that doesn't mean you can't talk about housing deflation - if for no other reason than to get the attention of people who should be concerned about this potential development.

Housing prices have been the most important of all prices in recent years - even more important than the price of oil.

For the last three years, the entire world economy has been powered by the American consumption of imported goods, enabled by ever-higher U.S. housing prices. No housing price rise, no rise in consumer spending, and a booming world economy quickly sputters.

This was Alan Greenspan's gift to Ben Bernanke.

'Flation Expectations Management

Whether you define 'flation as an economist does, using questionable government price indexes, or if you prefer the Merriam-Webster view that price changes are merely the result of the expansion and contraction in both money and credit and real 'flation lies there, in today's bubble economy, management is definitely required.

When prices are rising, care must be taken that they not rise too fast. Consumers will notice the quickening pace of price increases and step up their purchases to avoid watching their money lose value. This creates an overheated economy that must be cooled.

Inflation expectations are managed by restricting credit, raising interest rates, and talking a lot about being vigilant, so as to dampen economic activity, bringing prices back in line with long-term trends.

When prices are falling however, the opposite is true. Consumers will notice the decline in price levels, and hence the increasing value of their money, and defer purchases in the hopes of getting a better bargain in the future.

Deflation expectations must be dealt with by opening the money and credit spigots wide, so as to convince would-be savers that their money is better spent than kept. Economic activity increases with the higher level of spending and prices return to long-term trends.

But when some prices rise and some prices fall, the 'flation expectations management business becomes difficult. When the cost of energy and services increase while the price of homes decrease, what is the manager to do?

Make money and credit tighter or looser?

It seems the two 'flations, and how both the American consumer and makers of monetary policy view them, are opposing forces in our bubble economy - an economy that is not so easily controlled anymore. How does one go about seeing that certain prices don't rise too much and others don't fall too much?

That, clearly, is a question that keeps Ben Bernanke up late at night - how to manage both inflation and deflation expectations.