Thursday, May 28, 2009

Deflation - An Economist's Illusion or the Real Deal?

Okay, so the Obama administration says we are in a period of deflation as opposed to the typical inflation we normally see. Deflation, a rather pathetic word that reminds me of a flat tire. But deflation should be great because it means prices are going down, not up. But there is one problem, some major price categories seem to be going up to me.

To understand what people are talking about let us take a look at the definition of the term "deflation" and what it really means.

Question: What Is Deflation?

Answer: The definition of deflation is when asset and consumer prices continue to fall. This may seem like a great thing to consumers, except that the cause for deflation is a long-term drop in demand.

Unfortunately, a drop in demand means that a recession is already underway, with job losses, declining wages, and an ongoing decline in the value of your home and your stock portfolio. Deflation is a result of businesses dropping prices in a desperate attempt to get people to buy their products.

Officially, deflation is measured by a decrease in the Consumer Price Index. However, the CPI does not measure stock prices, which retirees use to fund purchases, and businesses use to fund growth. It also does not measure housing prices, instead using rental equivalent. This often lags home price declines, and underestimates deflation in the CPI.

To combat deflation, the Federal Reserve executes an expansionary monetary policy. It reduces interest rates, and increases the money supply in an attempt to jump-start economic growth. In addition, the government can offset deflation with expansionary fiscal policy. It can put more money into circulation by lowering taxes, increasing government spending, and incurring a temporary deficit to do so. Of course, if the deficit is already at record levels, that tool may no longer be available.

Like inflation, deflation is very difficult to combat once it is entrenched. As businesses and people feel less wealthy, they spend less, reducing demand further. Prices drop in response, giving businesses less profit.

I don't know about you but it seems to me gas has started rising again. In fact the price per barrel of crude oil, which impacts on many supplemental products from transportation to fertilizer, has increased 90% since the beginning of this year alone and now stands at about $62.00 a barrel. No wonder OPEC did not reduce the amount of oil produced this week when the price now is above the 2007 prices in place before the outrageous price spiral.

Taxes are certainly up, especially state and local taxes, and you can bet the aftermath of the incredible federal spending will be substantial future price increases. Obama has already set a new record for the annual federal deficit and the stimulus and bailout programs are just starting to spend money with multi-billion dollar bailouts waiting in the wings for a bankrupt Chrysler and General Motors and a teetering AIG insurance giant.

A lot of food prices are up or they have cleverly repackaged items so we are paying the same for less goods, thus really increasing the price. Organic foods are not dropping either even though there has been a push to be healthy and sales are up.

Certainly restaurant prices do not seem to be falling. In fact with the addition of designer coffee in McDonald's some prices are actually going up as well. When there are "specials" it usually means you get a silver dollar sized hamburger instead of the meat eaters delight we've grown to love.

Medical and health insurance rates continue to spiral in spite of the Obama efforts to overhaul the health care industry. After a decade of double digit annual price increases this year prices are expected to drop down to just a 7% increase. Only in our nation's capitol could a 7% increase be treated as a drop in prices.

As the definition said, two of the most important cost factors missing from the deflation figure are stock prices and housing prices. No one will question that these two have dropped with stocks, and your retirement funds, still about 40% less in value than a year ago.

Housing prices have also gone down, a lot in some areas. But the national market tends to be local market driven so one area may have no loss in value over the recent years (2006 - 2009) while a neighboring area could have substantial loss of value.

Take, for example, the case of Coltons Point. The Washington, DC metro area including Northern Virginia and Maryland has suffered an overall loss of value of about 24% the past year. However, a Washington Post survey of all home sales in the metro area the past year shows there are a few locations where prices have actually increased. One of these unique areas is the riverside resort of Coltons Point where values have increased by over 3% the past year.

Still nationwide stock and housing prices have dropped but neither is even factored into the deflation model which makes me wonder just what value is the economic news on deflation? It is distorted since it missed two of the biggest cost factors. The Consumer Price Index which is the basis for determining inflation or deflation is often a lagging indicator of economic performance much like unemployment figures. Conversely the stock market is a forward indicator of economic growth having already factored in jobs reports before they are even released.

The Labor Department figures on new unemployment claims this week dropped well below analysts expectations for the 2nd time in three weeks yet the unemployment rate climbed to 8.9% and the lagging figure could reach 10% later this year even if the economy is in a full recovery cycle as the Coltons Point Times and more recently other financial news services are beginning to predict.

In light of all this conflicting information and simultaneous upward and downward economic pressure my advice is for you to ignore deflation and inflation reports and the endless speculation about them as it is something the Federal Reserve must manage and we the people have no role in what the Federal Reserve does with our money anyway.

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