Beware Of Deflation

Prices could be headed downward. That's bad news for businessmen who aren't prepared.

Most businessmen have their strategy down pat for coping with inflation. They buy more inventory, because the carrying cost is less than likely future price increases. They expand aggressively, buying office buildings, plants, and machinery because they believe the value can do nothing but increase. And many try to borrow at a long-term fixed rate, certain that rates will continue to rise and their loan will be repaid with cheaper dollars. So far, these strategies have worked.

But the times may be changing. "While five years ago there were no signs that inflation was going to abate, today there are growing bits of evidence that suggest we may be turning the corner," says Gary Driggs, president of Arizona's Western Financial Corp. and Western Savings and Loan.

Driggs is a man with a pretty good record for predicting the future when no one else sees it. As long ago as 1976 he foretold the current oil glut, a decline in trade union power, and a lessening of government's role in the economy.

Driggs says businessmen now have to ask themselves whether the aggressive tactics developed for inflation will adequately deal with an economy where there is either little inflation or even deflation -- declining prices.

In the 205-year history of the United States, the number of years of deflation has nearly equaled the number of years of inflation. Prices in 1933 were about as low as they had been in 1814. But because the last period of deflation was long ago during the Depression, we tend to forget that the economy has cycles. And we even forget that as recently as the period from 1952 to 1965, inflation averaged a mere 1.3%.

Are we entering a period of deflation?

Driggs feels it's too early to tell if we are actually going to experience deflation, but he believes that "a moderation of inflation is highly probable." He predicts a 5% to 7% inflation rate within the next two years.

There are at least seven bits of evidence that inflation will be turning around:

* The price of oil, according to Driggs, is the most apparent. "There is a case to be made that rapid inflation was triggered by the large increases in oil prices following the October 1973 embargo," says Driggs. He points out that OPEC has lost nearly one-third of its market in the past seven years. High prices have stimulated people to discover additional oil and to use less. "It's obviously hard to increase prices rapidly when consumption is off," Driggs comments.

* "Wheat and corn are major factors in price indices," Driggs says. He points to the apparent record crop for the two commodities this year. "For the immediate future," Driggs contends, "food does not seem to be a factor likely to cause any significant price increase."

* Prices of other commodities are either stable or declining as well. "There has been a 14.4% decline in dollars in worldwide commodity prices over the past year," says Driggs. "Food is off 16.9%, industrial commodities off 8.4%, fibers down 10.5%, and metals down 8.0%."

Driggs admits that part of this decline can be attributed to the strengthening of the U.S. dollar, but the strengthened dollar itself is an indication of reduced expectations for inflation in the United States.

* The recent 50% drop in gold prices means investors are no longer as desperate as they had been for an inflation hedge. "The price of gold is excellent evidence of the level of apprehension in the world about inflation," according to Driggs.

* Real estate prices are no longer soaring. "Depending on how you measure it, housing prices may actually be level or declining for the past year," says Driggs. He says he expects housing prices will now rise at about the average rate of inflation. Historically, the increase in housing prices has exceeded the rate of inflation.

Driggs stresses that none of this evidence is conclusive. He says that businessmen should keep track of economic indicators this year so they can better prepare their strategies. He suggests they watch money-supply figures and commodities and precious metals prices in the Wall Street Journal and other major newspapers. Recently commodities prices have been at one-year lows; if this continues, it is an indication of declining inflation.

Media stories on housing prices, oil prices, and the political environment will also indicate economic trends.

Perhaps the best indicators to the businessman are his own suppliers. "Are they anxious to see you? Are they offering you discounts?" Driggs asks. "Are they rude to you?" he smiles. If inflation does indeed begin the downward trend that Driggs predicts, you may find your suppliers are rude to you much less often. They will be stuck with excess inventory and may be very willing to cut prices. And they'll rarely be too busy to return your phone calls.

* Money-supply growth is no longer accelerating. "Ultimately, to have slow inflation is to have slow money growth," Driggs contends. Inflation, he says, "is caused by printing more money for expenditures voted by government officials."

The growth rate of M1B, the supply of currency and both interest-bearing and noninterest-bearing checking accounts deposits, rose from about 2% a year in the early 1960's to 8% a year in the late '70s. Since 1977, however, the growth rate has ceased to accelerate and has in fact declined a bit. M1B has grown at about a 6% annual rate over the last six months.

* The shift to the right in both the electorate and government policy will also help lessen inflation, Driggs argues. People are not urging their elected officials to vote new spending programs, only lobbying on which ones to cut. The new tax laws encourage businessmen to invest in productive facilities that will produce more goods and services, moderating inflationary pressures. Government toughness toward unions is still another indication that politicians are seriously trying to control inflation.

If you see all the indicators continuing to spiral downward, it's time to re-check your strategy. Are you prepared for deflation? Here are some questions to ask yourself:

1. How liquid am I? "Have more cash on hand than normal" is rule No. 1. Cash can be invested in short-term accounts at your bank, money market funds at brokerage houses, U.S. Treasury bills, or large companies' commercial paper -- anything that can be converted back to cash quickly.

2. How much debt do I have? It's great to carry debt in inflationary times and terrible in periods of deflation. If you must borrow money, seek a variable-rate rather than a fixed-rate loan. If you are locked into a high, long-term, fixed rate, try to negotiate the right to pay off the loan without a penalty.

3. How much do I have in inventory? The carrying cost of inventory these days may more than offset the probable increase in the inventory's value. "Be careful about contracts that obligate you to buy a fixed amount of inventory," Driggs warns.

4. Have I promised too many wage increases? "Never promise a minimum fixed adjustment that you're obligated to, no matter what," says Driggs. "You shouldn't get any kind of floors into contracts."

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