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Falling prices could bring a nasty hangover

Image: Wal-Mart shopper
Shoppers move through the aisles at the Wal-Mart Super Center in Springfield, Ill.Seth Perlman / AP

Call it one of the recession's silver linings — with each passing day, the purchasing power of each consumer dollar is getting stronger.

But if it keeps up, and prices continue to fall, that boost in buying power comes with some nasty side effects, say economists.

The government reported Friday that consumer prices fell over the past 12 months at the fastest rate since Dwight D. Eisenhower was president.

Prices were flat in April after dropping 0.1 percent in March, leaving the Consumer Price Index 0.7 percent lower than it was a year ago, according to the Labor Department. That's the biggest 12-month decline since June 1955.

General deflation of any kind has not been seen in the United States since the 1950s, and benefits cash-strapped consumers looking for bargains and retirees trying to live on a fixed income.

Falling prices also help savers. If consumer prices are falling 1 percent a year, the real (price-adjusted) return on a bank CD paying 2 percent magically becomes 3 percent.

And falling prices are a terrific antidote to the stagnant wage growth that has weighed on many U.S. households since the last recession ended in 2001. Even if your boss freezes your wages, when prices are falling 2 percent a year, your real wage is rising 2 percent.

The flip side is that borrowers and consumers carrying heavy debt loads see their burden increase. As prices fall, the purchasing power of your dollars goes up, so your future monthly payments will take a bigger bite out of your spending power. That means if you’re paying 8 percent on a mortgage, and prices are falling 2 percent a year, your borrowing cost in real, price-adjusted terms is 10 percent.

Household borrowers are not the only ones who need to worry about falling prices. The threat of continued deflation is a thorny problem for businesses, and government policymakers including Federal Reserve Chairman Ben Bernanke. The risk is that the drop in prices begins to feed on itself. Lower prices take a big bite out of employers’ profits, which forces wage cuts or layoffs. That cuts consumer spending and demand, which brings more price cuts to spur sales.

“Once you get more downward pressure on wage and prices and it’s hard to get yourself out of that cycle,” said Brian Bethune, chief U.S. economist at IHS Global Insight.

Take the falling price of airline tickets, which have dropped for eight straight months — down another 1.5 percent in April, according to government data.

As the recession grinds on, consumers continue to postpone discretionary travel, further weakening demand. Business travel is also off sharply according to Mark Masuda, who manages airline partnerships with Travel Leaders, a Minneapolis-based travel company.  

“They’re putting the screws to their budgets and holding their travel and entertainment expenses down,” he said. “Once they get comfortable that consumers are coming back, they’re going to have to get out and see customers and find new customers and you’re going to see that travel increase as well."

Until then, the only way for airlines to fill planes is to cut fares.  If that keeps up, airlines can afford to lose only so much money before they make steeper cuts in their schedules, which means lower wages for their workers. As those workers spend less on other products and services, the lower demand forces wider cuts in prices.

Since the recession began over a year ago, changes in consumer prices have been uneven. While some categories have fallen, others continue to post gains, especially for goods and services where prices are regulated or changes take time to work their way through the system. Medicare reimbursements don’t fall if fewer patients show up for a given procedure. When bus ridership goes down, fares rarely follow. (Fares may even have to go up to make up for the revenue shortfall.) If an office building has lots of vacant space, most business tenants won’t get a break on their rent until their lease it up.

But there’s evidence that consumer prices are falling faster than the so-called “headline” consumer price index.

Take housing prices, for example. As of February, home prices nationwide had fallen by more than 18 percent in the prior 12 months, according to the S&P/Case Schiller Home Price Index. The National Association of Realtors, which uses a separate formula, figures home prices in the first quarter of this year were nearly 14 percent lower than a year earlier.

But the housing component of the government’s price formula — which makes up about a third of the Consumer Price Index — shows housing costs have risen about 1.5 percent in the 12 months ending in March.  One big reason is that since 1983 the government has measured homeowners’ housing costs with “rental equivalence” — what they would pay to rent their own home. (The Labor Department says it made the change to strip out the investment gains homeowners enjoy when home prices are rising.)

Critics of the inflation formula say it tends to understate the inflationary effects of housing prices on the way up and is now underestimating the drop in consumer prices as housing prices have fallen.

“The reality is that deflation will become more apparent in the CPI numbers as we look forward over the next few months,” said Bethune.

Economists are divided on how long prices will keep falling. A lot depends on how long it takes for the economy to start growing again. With consumer spending making up 70 percent of the gross domestic product, that won’t happen until consumers get back in a spending mood.

The economy has been shedding more than half a million jobs a month, so most households have sharply boosted savings for a rainy day. Until the job market stabilizes, consumers will likely remain skittish.

Consumers' discretionary spending in April dropped 90 percent compared to a year ago, according to Britt Beemer, Chairman of America's Research Group, a market research firm.

“The only thing they bought this year compared to last year was major appliances because they had to buy them because the one they had in their home was broken," said Beemer. "That tells you their mindset.” 

Falling prices may throw even more cold water on spending. Why buy a new car if you expect prices to fall further in the next six months?

Consumers aren’t the only ones motivated to hoard cash when prices fall. Banks lending money become leery about accepting collateral that is losing value: If the borrower doesn’t pay back the loan, the bank is at greater risk for losing money.

American households have also cut spending and boosted savings to try to fill the huge hole created by the twin collapse of the stock and housing markets, which destroyed trillions of dollars of wealth they were counting on for retirement. With 401(k) accounts in tatters, millions of older Americas are putting off retirement and regrouping.   

“If a lot of consumers think they're going to have to work three (or) five years longer, they're not going to change their spending habits for a long time,” said Beemer. “I feel we're going to be in this retail deep freeze until Labor Day 2010. There's just too many issues out there consumers have got to get beyond before they’re going to have any money to spend.”

A true downward deflationary spiral hasn’t been seen in this country since the Great Depression. Now, the threat of deflation has spurred the Federal Reserve to undertake an unprecedented program of “reflating” the economy with a $1 trillion expansion in lending to pump more money into the financial system.

The hope is that all that money will offset the collapse in wealth from the housing and financial markets and prevent deflation from taking hold.

In the short run, the plan seems to be working. The drop in housing prices is slowing; so is the rise in job losses. The historic government response has been generally well-received by the public. But it remains to be seen what the longer-term impact of these policies will be.

“The electorate doesn't have a high degree of tolerance for a lot of pain,” said Michael Darda,   Chief Economist at MKM Partners. “People don't like rising unemployment and falling incomes. So they want government action.”

But the long term impact of these policies is still an open question, said Darda. The huge expansion of government debt could bring a crushing tax burden that hurts the economy. The Fed’s lending spree could bring major distortoins in the money supply and spark a longer-term bout of inflation.  

“(The government response) does certainly increase the potential for probably a more rapid rebound — and then a possibly a  hangover effect,” said Darda.