When the Federal Reserve announced "Operation Twist" in September, buying long-term securities in order to lower long-term interest rates, it sent an important signal: It's worried about deflation again.
Deflation to the Fed means substantial and chronic price drops for goods and services that risk creating a self-perpetuating downward price spiral. If buyers think prices will be lower in the future, they delay purchases, creating more economic decline, which pushes prices lower, and so on.
This is one form of deflation, but there are six others (see my latest book: "The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation"). Five forms are already in place in the United States. There's deflation of:
1. Financial assets. It started with the 2007 collapse in subprime residential mortgages, which touched off the swoon in stocks and bonds. Massive monetary and fiscal stimuli revived them starting in early 2009, but financial assets are sinking again under the weight of an increasingly recession-prone US economy, a likely hard landing in China, and Europe's sovereign-debt crisis. That crisis and ratings downgrades are forcing down the value of sovereign debt and bank shares.
2. Tangible assets. The 20-city house price index from S&P/Case-Shiller is down an average 4.2 percent from a year ago and 32 percent from its April 2006 peak. Moody's/REAL Commercial Property Price Index has dropped 43 percent from its October 2007 peak.
3. Commodity prices. The trend started earlier this year. Copper, which measures global industrial activity since it's used in almost all manufactured products, is down 28 percent from its peak in February. Cotton's off 53 percent since March. Even gold is down 12 percent from its early September peak after a meteoric rise. The hard landing I foresee for China will erode, probably destroy, the basis for the global commodity bubble – namely, the conviction that China will continue to buy all the industrial and agricultural commodities in sight.
4. Wages. With the US labor market so weak, the wage side of a wage/price downward spiral is firmly established. The unemployment rate, including those who have given up looking for work, is 16.2 percent, compared with the headline 9.1 percent. Real median household income was down 7.1 percent between 1999 and 2010; it fell 2.3 percent in the last year alone.
5. Currencies. This form of deflation has arrived as the world rushes to the US dollar. The US has serious problems but remains attractive relative to woeful Europe. The dollar is the route to the Treasury securities foreigners covet. The greenback is the only world reserve currency, and it has a huge, free, and deep market compared with the Swiss franc, now pegged to the euro.
So, five out of seven forms of deflation are at work. Two have yet to be established. The arrival of one – deflation by government fiat – is uncertain, but may not be far off. Currently, we have inflation by fiat, which includes all the ways by which, with a stroke of a pen, government can take actions that raise prices and wages – be it through legislation, new regulations, etc. But the 2012 election may spawn genuine tax simplification and other deflation by fiat.
The other form – the goods and services deflation that the Federal Reserve fears – can't be far behind, given all the other areas where prices are already falling. As global deleveraging persists, all these prices will be marked down as the world struggles to find a new equilibrium.
– A. Gary Shilling heads an economic consulting firm in Springfield, N.J., and is the author of several books.