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Energy prices are rising sharply. Gold prices have hit all time record highs above $1000 an ounce. Prices for food commodities are soaring as well. Food riots have been reported in Mexico, Cairo, and Sao Paulo among other cities. Everywhere you look, there are signs of inflation. And yet, a close examination of the historical record shows that every past credit event of any size has always led to deflation.

The case for deflation begins with the value of the dollar. While trade balances were once the most important factors in currency valuation, they have been replaced by the movement of capital. On the margin, the movement of capital is driven by its risk/return profile.

In each of the 1990s credit events, including the Russia debt restructuring, the Asian currency crisis, the Mexico Peso rescue, and the Long Term Capital Management meltdown, financial market fear created a rush to quality that gave a boost to the dollar and put downward pressure on prices. So far in the current credit crisis, just the opposite has happened. This may be about to change. A stronger dollar will be driven by weaker economic growth overseas, credit issues emerging in European banks and a cutting of interest rates by the European Central Bank. A reduction in European interest rates coupled with greater default risk in Europe will push the dollar higher. A higher dollar coupled with weaker global growth will put downward pressure on commodity prices, beginning the process of deflation.


An Avoidance of Risk: Irrational Fear
Falling commodity prices, however, are not enough to set off real deflation. What is required is a liquidity trap set off by the de-leveraging of both bank and household balance sheets. In the reach for yield, banks went to extraordinary lengths to take on dangerous levels of leverage. This was done through both on balance sheet borrowing and the creation off-balance sheet entities often referred to as Structured Investment Vehicles or SIV’s.

With asset prices falling, banks are being forced to de-leverage by selling assets, raising cash and reducing debt, creating a bubble like demand for cash. In a liquidity trap, cash becomes a bubble asset. Interest rates can be pushed to zero but are still no incentive to move out of cash by investing in real assets because cash is needed to retire debt. Deflation also generates a real return to the holder of cash, adding to the incentive to de-leverage. Even as interest plunged in the first quarter, business investment in both structures and equipment fell.


Short-Term Interest Rates: Three Month Treasury Bills 2007-2008

De-leveraging deflates asset prices and reduces investment incentives. The Federal Reserve is fighting this by aggressively cutting interest rates. In this environment of irrational fear, the expectation of falling asset prices reduces all incentive to invest even with interest rates at zero. This is what happened in Japan in the early 1990s. The need for cash eventually pushes businesses to cut inventories which in turn puts downward pressure on consumer prices.


The Way Forward
While liquidity traps and the deflation they spawn are rare. There are two paths out of them. One is to allow asset markets to adjust, the other path demands government intervention. Herbert Hoover’s Treasury Secretary Andrew Mellon described the free market liquidationist approach when he noted that the solution to the 1929 downturn was to:

Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate… Values will be adjusted, and enterprising people will pick up the wrecks from less competent people.

Not allowing home prices to fall would be a little like trying to prop up the stock prices of internet bubble stocks. The greater the effort that is made to keep housing prices from falling, the longer the current recession will last and the deeper the gathering liquidity trap will become.

The other alternative is to have government step in and do the investing that the private sector is unwilling to make. Public sector investments in infrastructure, or alternative energy could stimulate economic activity enough to offset the deflationary effects of contracting bank balance sheets. The Japanese made a valiant effort to spend their way out of their liquidity trap in the 1990s with only modest success.

Implications for Food Retailing: While ever higher inflation seems like the most likely forecast, there is a risk of deflation. A deflationary environment rewards cash and punishes debt. For consumers, the emergence of deflation would be particularly punishing given the high level of household debt. For retailers, the possibility of deflation is something they should consider in their longer term planning for the future.

To comment on this article or pose another topic for this columnist, contact Carl Steidtmann at csteidtmann@deloitte.com.