Still Think Deflation is Impossible?

“Toyota plans to raise price of cars in Japan for the first time in 16 years.”

Financial Times, August 26, 2008

In recent news, inflation is a recurring scare.  As the headline above indicates, Toyota, one of the most efficient car manufacturers in the world, is being forced to raise prices in the home market.  Disturbingly to inflation hawks, it is not increased consumer demand or enhanced quality that is driving the price hike, but the rising cost of steel and other materials.

Our preoccupation is not with Toyota’s price increase, which will likely be a modest 2-3 percent, but by the fact that the company had flat prices in Japan for 16 years during a period when auto prices were rising virtually everywhere else in the world.  To put things in perspective, the last time Toyota raised prices in Japan, President Bush was the owner of the Texas Rangers baseball franchise and President Clinton was still the relatively unknown governor of Arkansas. 

Rising food and stubbornly high oil and gas prices will likely continue to grab the media’s attention for the next several months.  But let us look at the medium-to-long-term picture:

Home prices in America are falling and still show little evidence of stabilizing. Rising prices, high debt levels, and less access to new credit have already started to crimp consumer spending. Banks, hedge funds, and other financial companies are “deleveraging,” which means that they are selling assets and raising new funds to pay back their existing debts. So despite Federal Reserve attempts to “print money,” credit is being retired as fast as it can be created. 

Angry voters are nudging their representatives to “do something” about the biofuel subsidies and speculation that have combined to send food prices sharply higher. Finally, and perhaps most importantly, Baby Boomers are beginning to save for retirement, taking money that would ordinarily be spent in the economy out of circulation.

Do any of these trends make inflation seem likely? Prices are indeed likely to rise for the next few months as the commodity bubble slowly deflates.  But longer term, we see a long period ahead of stagnant or even falling prices.  As the example of Toyota in Japan proves, deflation is real. We expect it to occur in late 09 or early 2010.