The Recovery: Why Deflation Remains a Threat

Bargains are everywhere in America these days. Men's shirts and sweaters were 3.4 percent cheaper this April than a year earlier. Prices also fell for eggs, peanut butter, bananas, potatoes, hotel and motel rooms, cosmetics, curtains, rugs, tools, and lawn care. Excluding gasoline and other energy items, the consumer price index rose just 0.9 percent for the year. That's the smallest increase since January 1962, when John F. Kennedy was President.

Everybody likes to save money, but flat to falling prices are not entirely good. They're a symptom of continued weakness nearly a year after the U.S. economy supposedly hit bottom. The same softness of demand that keeps goods cheap is pressuring workers. Annual growth of average hourly earnings fell from 3.5 percent in April 2007 to 1.6 percent this April.

The economic recovery, while welcome, isn't yet strong enough to ensure against the risk of deflation, in which prices fall across the board for an extended period. Deflation caused by a shortfall in demand can be dangerous. People delay purchases, waiting for lower prices, which exacerbates the slowdown. Bankruptcies rise because even though pay falls, debt levels don't. To keep deflation at bay, the Federal Reserve's Open Market Committee voted in April to keep the federal funds rate at near zero. Even with an overhang of more than $1 trillion of excess reserves in the banking system, ready to be lent, committee members cut their inflation forecasts by 0.2 percentage point between the January and April meetings, to a range of 1.2 percent to 1.5 percent for this year.

Turmoil in Europe is amplifying the risk of deflation in the U.S. It's driving up the dollar's value, making American goods less competitive in world markets and retarding growth. Europe's problems also are pushing down the U.S. stock market, which makes consumers fearful and less likely to spend. The Standard & Poor's 500-stock index has fallen 12 percent from its April high. A sharp decline in oil prices since the end of April shows that growth worries are worldwide, since it's global demand that determines the price of oil. Crude hit $71 a barrel in late May, down from $86 at the end of April. Gold is moving the other way, rising to more than $1,200 an ounce by late May from a recent low of less than $900 in April 2009, as investors seek a refuge from chancy markets and banks. All the grim indicators have made their mark. "Call it a nightmare," says one of the most prominent bears, David A. Rosenberg, chief economist and strategist at the Toronto-based investment firm of Gluskin Sheff + Associates.

The decline of output during the 2007-09 recession was so steep that there's still a huge amount of excess productive capacity. According to Federal Reserve data, only 69percent of total industry capacity was used in April, vs. an average of 81percent in the previous 38 years. As for labor, the unemployment rate remains stubbornly high because every uptick in hiring encourages more people to start looking for work again—and thus boost the official jobless rate.

The optimistic take on the economy is that the threat of deflation is temporary and will diminish as excess capacity gets eaten up. Kurt Karl, chief U.S. economist of Swiss Re, says employment gains are producing income that will be spent, generating more jobs and more spending in a virtuous upward spiral. "I'm still bullish," says Karl, adding, "employment growth has turned a major corner." Deflation, he adds, "would be a permanent kind of problem only if you didn't have any employment momentum." He predicts a decrease in the unemployment rate from 9.9percent in April to about 9.5percent at the end of 2010 and about 8percent at the end of 2011.

Certainly there are some signs of progress. On May 25 the Conference Board announced that its May index of consumer confidence rose to the highest level since March 2008. MasterCard Advisors' SpendingPulse measure of consumer purchases has ticked up sharply since early 2009. Luxury retail chains including Barneys and Saks (SKS) are scaling back discounts and promotions they offered to attract shoppers during the recession. In February, Tiffany (TIF) raised prices across the store. Consultants Bain & Co. say U.S. sales of luxury goods may rise 4percent in 2010 after declining 17percent in 2009.

There are worrisome signs, though, that the recovery could stall. Employment has been boosted by the Census Bureau's temporary hiring for the decennial census, but as summer approaches that source of employment will fade. Job creation will slow as the year goes on and be "anemic" in 2011, predicts Rajeev Dhawan, director of the Economic Forecasting Center at Georgia State University's J. Mack Robinson College of Business. Says Sumit Chandra, a supply chain expert who is a partner at A.T. Kearney consultants: "The recovery is real. It's happening. But I think the magnitude of the recovery, the level of confidence we have in it, is fragile."

Kelly Services (KELYA), the temporary help firm, sees the tentativeness of the expansion at ground level. Demand for its services is strong because companies "want to maintain maximum flexibility" in case the recovery fades, says George S. Corona, Kelly's executive vice-president. Meanwhile, upward pressure on wages is nil in most segments, says Corona. "We have a lot of résumés coming in the door," he says. "We're not having to work hard to find people." Exactly. Cheap shirts and sweaters are cold comfort for unemployed people who are sitting at home in their pajamas.

With Cotten Timberlake

The bottom line: The recession created so much extra capacity that the economy is struggling to absorb it, even as the recovery takes hold.

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