The Peril of Lower Prices

Yesterday, the U.S. Labor Department reported the core rate for Producer Prices fell “unexpectedly” last month by 0.3%. This report obviously caught analysts and economists off guard.

I’ve been writing for months about how the U.S. Fed should be more concerned with deflation than inflation. Yesterday’s news provides ammunition to my view. Sure stocks and bonds rallied yesterday because lack of inflation means interest rates in the U.S. will not rise again at the next Fed meeting. But long-term, stocks will be faced with immense selling pressure if prices continue to fall (deflation).

New cars, computers and men’s clothing led producer prices lower last month. To this, I’d also like to add housing as a deflating factor. In most markets in the U.S., especially the once hot real estate pockets, house prices are easing.

The peril of lower prices is simply this: What you’ve borrowed money to buy (such as a house) falls in value, while the debt you’ve accumulated to buy the item does not fall in value. Deflation is about the worst possible scenario for the U.S. economy.

And, under a deflationary environment, the U.S. dollar would come under immense selling pressure by foreigners. American investors should be looking for investments that benefit from a lower valued U.S. dollar. Ideally, the stocks of American companies that sell their products predominately outside the U.S. could be attractive.

In the event deflation rears its ugly head, U.S. Federal Reserve Chairman Bernanke will need to flood the proverbial “gates” with liquidity. He’s to do this by aggressively lowering rates and increasing the money supply. Maybe the Fed sensed some deflation earlier this month when it decided not to continue its campaign of higher interest rates.

As economic data is released, I’ll keep you posted on the depth of the deflationary situation for the U.S. and what it could mean for investors like us.