The fizzle

Some people wonder why interest rates would fall when the economy’s okay. They want rate pain, mostly to force house prices down.

Well, just to prove the world is beyond understanding, yesterday we let an economist hyperventilate about the imminent threat of inflation roaring back. Today we offer an even scarier brute. Deflation.

Lots of smart folk worry the CB has kept rates too high, too long, restricting credit and growth and paving the way for a nasty trip down. They point to economic slack building. Unemployment is going up. Productivity is falling. Price growth has crashed too fast – from over 8% down to 2.5% in less than two years. Not good, they say. And despite Canada’s rapid population growth, the economy is wonky. Without all those new consumers, we’d be in contraction.

While I disagree with most everything economist David Rosenberg utters, this resonates: “The Bank of Canada’s own estimate of potential non-inflationary growth from now to 2027 is 1.8 per cent at an annual rate. The economy is now running at half that pace. Ergo, the primary risk in Canada is homegrown deflation as excess capacity builds, not inflation.”

But wait. How can deflation be bad, the kiddos cry? We want cheaper bungalofts and Brizo bathroom fixtures. Bring it on.

First, understand the terms. With inflation, stuff goes up in price. Disinflation (we have it now) means price increases steadily slow. Stagflation is the unhappy combo of rising prices but a moribund economy (an energy shock decades ago did that). Deflation is the worst-case scenario for an economy. It starts to die.

Here’s a definition from the Bank of Canada itself. It’s accurate.

Deflation, on the other hand, refers to a persistent fall in the level of the total CPI, with negative inflation being recorded year after year. The one major episode of sustained deflation in Canada was during the Great Depression of the 1930s, when the overall level of prices fell by more than 20 per cent over a four year period. Deflation can be particularly harmful when caused by a protracted sharp contraction in spending (as in the 1930s), which triggers a persistent fall in the general level of prices. This can throw the economy in a deflationary spiral, as incomes fall and the real debt burden of borrowers increases. In such a case, ongoing price declines lead to lower production and wages, which further reduce demand by consumers and businesses, leading to still lower prices, and so on.

In practical terms, prices fall because they can’t go up or even stay stable. Demand collapses, as does confidence. People are distressed. They delay buying things, believing prices will be lower later. Companies fold. Layoffs are everywhere. Incomes decline so people have less to spend. Even worse, debts become much harder to pay because dollars are scarer, and worth more. Unlike in inflationary times when the burden of debt melts a bit, during deflation that monkey grows heavier on your back.

Humans, being human, reduce spending and increase saving because times are dodgy. Money is sucked out of circulation, seriously hurting employers and leading to a big spike in unemployment. During the 1930s in Canada, the official jobless rate was 19% in June of 1933, although it’s believed the true stat was closer to 30%.

Declining sales mean companies have no option but to reduce overhead and dump workers – or go insolvent. Before that happens, employers demand wage concessions. Either employees and unions comply, or the work disappears. Meanwhile governments are no longer capable of filling the social gap – already they’re running $40 billion deficits during good times. Imagine the situation during a period of deflation and mass unemployment with a crash in personal and corporate tax revenues.

Would houses fall in value?

You bet they would. Like stones in a pond. But sales would also take a deep dive, as the jobless rate rose, incomes fell, buyer confidence wavered and lenders drew in their horns. Concurrently, debt levels – historically high – would become unbearable obligations for many. Defaults would rise. Listings surge. Lenders would be hit. And so would lending.

By the way, all this is not fiction. It’s started recently in China.

On Monday came more evidence of it, atop that country’s continuing real estate collapse. Consumer prices have stopped increasing and incomes are sagging. Entry-level salaries in the country’s all-important EV sector have dropped almost 10%. Core inflation is the weakest in three years now. Deflation expectations have whacked the financial markets, driving Chinese bond yields to record lows.

So what do we make of this? What can you do, if worried about the rapid emergence of deflation?

Central banks can lower interest rates – quickly and profoundly. That injects stimulus into the economy, expands credit, encourages spending, stabilizes prices, helps ease corporate and public debt financing, reduces layoffs and bolsters consumer confidence. Yeah, it might also boost real estate values – temporarily.

As individuals you can ignore all this. Or not. Those deciding to protect themselves will reduce debt as fast as possible, load up on fixed income investments (bond prices will spurt higher as yields tumble) and do everything necessary to stay employed. Even if you drive trains or airplanes for a living.

Isn’t change fun?

About the picture: “Here is our rescue cat Birdie shortly after her adoption,” writes Bev. “It took her awhile to settle in and now she considers the backyard her kingdom.  Thank you Garth for your excellent advice over the years.  Switched from mutual funds and in 2014 direct invested with a handful of ETF’s.  Best decision ever! We are living our best lives in San Pareil, Parksville on beautiful Vancouver Island.”

To be in touch or send a picture of your beast, email to ‘garth@garth.ca’.

Source: https://www.greaterfool.ca/2024/09/09/the-fizzle-5/