Commentary: Can Inflation Get Too Low?

Want to give investors in the stock-market a good scare? Sneak up and yell: "Inflation is coming!"

For people who lived through the 1970s and early 1980s, nothing is more frightening than a return to such inflation-prone times. From 1972 to 1982, the Standard & Poor's 500-stock index rose a meager 1% a year, while consumer prices soared at a 8.7% rate. Since then, the U.S. has seen the opposite combination: a stock market boom accompanied by slowing inflation. That's why investors run and hide every time there are signs of reviving inflation--and cheer at any signs of slowing prices.

But, as the saying goes, be careful what you wish for. Low inflation is helping stock prices now--just as healthy corporate profits have done. But as the economy slows, so, too, will the growth in profits. In such an environment, the biggest risk for investors may be the prospect of actual deflation. Recent research and evidence from abroad suggest that deflation, rather than being a boon for the stock market, may instead be linked to falling equity values.

CLOSE TO ZERO. Right now, the consumer inflation rate for nonenergy, nonfood goods such as toothpaste, cars, and shirts is running about 1.3% (chart), the lowest in three decades. That's the rate as measured by the Bureau of Labor Statistics. But many economists, including Federal Reserve Chairman Alan Greenspan, believe reported inflation may be overstated by 0.5 to 1.5 percentage points--which implies that the "real" inflation rate for goods is close to zero. Already, makers of a number of products are experiencing falling prices (table).

Any economic slowdown will make price declines more likely, especially since many businesses will be faced with underused factories. Riding the investment boom of the 1990s, productive capacity in manufacturing has been growing at an astounding 4.4% a year. And the next recession, if and when it comes, will put more of a damper on prices. The downturn of 1990-91 reduced inflation by about 1.5 percentage points. A similar drop during the next recession could bring on deflation--the overall price level for goods and services that companies sell would be falling rather than rising.

What would happen to stocks then? The conventional wisdom is that lower inflation helps stock returns. But what if inflation is so tame that prices barely rise or even fall? The stock market's happy reception of price moderation in recent years may turn out to have been an anomaly, according to three economists at New York University's Stern School of Business who have looked at two centuries of stock market behavior. Matthew Richardson, Jacob Boudoukh, and Robert Whitelaw found that low inflation over a five-year period was accompanied on average by lower stock-market returns.

Recent performance in foreign markets bears them out. In the 1990s, the countries with the lowest inflation rates, Japan and France, have also had poorly performing stock markets. Japan has gone through a major deflation, with wholesale prices dropping by 7% since 1990. At the same time, the Nikkei index remains below its 1990 levels. In France, wholesale prices and stock prices have remained virtually unchanged over the same period.

TELLING SIGN. America's one extended experience with deflation--the Great Depression--showed that falling prices are bad news for stocks. Following the stock market crash of 1929, consumer prices dropped sharply in the early 1930s, and stock prices continued plummeting. Although they revived later in the 1930s, it took two decades for stock prices to reach pre-crash levels.

Why the negative link between the stock market and deflation? For one thing, deflation is often a telling sign of a sharply slowing economy. And the same forces that drive prices down also hammer corporate profits. But deflation carries its own penalty as well. Simply put, it's harder to make a profit as prices fall. Inventories are worth less the longer they sit, while labor, rent, and other costs tend to be fixed in the short run.

True, lower inflation or deflation should drive down interest rates, and those lower rates should in turn buoy stock-market prices. During most periods, though, the stock market is more influenced by corporate profits than it is by interest rates. Since 1991, both the stock market and corporate profits, as measured by the government, have risen about 11.5% annually.

Corporate America has talked a good game about becoming lean and mean. But are companies flexible enough to cope with widespread falling prices? If not, deflation may stop the bull market in its tracks.

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