Deflation fears are in the air
____________________________________________________
Local manufacturers, banks, retailers vulnerable
By Kevin Davis
Crains Business Chicago
May 26, 2003
Deflation, the latest concern among economic policymakers, is the last thing the struggling Chicago economy needs.
Federal Reserve Board Chairman Alan Greenspan last week gave his strongest warning yet about the potentially crippling effects of a prolonged fall in prices and wages.
"We at the Federal Reserve recognize that deflation is a possibility," Mr. Greenspan told the Joint Economic Committee of Congress. "Even though we perceive the risks as minor, the potential consequences are very substantial and could be quite negative."
Mr. Greenspan hinted that the Fed might further reduce interest rates to stave off deflation, yet despite his warnings, there appears to be little alarm among Chicago-area companies.
"We're not concerned with deflation because we're more a global business," said a spokeswoman for BorgWarner Inc., a Chicago-based supplier of auto parts.
Maybe they — and other area companies — should be more concerned. The local economy is concentrated in the industries most vulnerable to deflation: manufacturing, retail, consumer products, banking and real estate. Its effects would range up and down the corporate food chain, from the area's many small and mid-sized industrial companies to the likes of retailer Sears, Roebuck and Co., consumer products powerhouse Fortune Brands Inc. and manufacturing giant Illinois Tool Works Inc.
Falling prices for finished goods would squeeze revenues at local manufacturers, forcing them to curtail investment, cut wages and lay off workers. But it wouldn't stop there: Unemployed workers would have less to spend on goods and services, housing and debt repayment, further fueling the cycle.
"It spirals down," said Michael S. Miller, chairman of the economics department at DePaul University in Chicago. "This is why deflation is so miserable. Deflation would be very damaging."
Paradoxically, falling prices don't translate into more sales, as consumers put off purchases, thinking they will get an even better deal if they wait longer. "It feeds on itself," Mr. Miller said.
One-two punch
As consumers wait, profits will shrink at local companies, many of which still haven't shaken off the effects of the recent economic slump.
"Companies would have few choices but to slow production, cut costs and lay more people off," said Carl Tannenbaum, chief economist at Chicago-based LaSalle Bank N.A. "This is the main fear — that deflation would distort normal spending and production standards. If it prompts conservative management responses, it will ripple throughout the economy."
Those ripples would wash over area banks already grappling with shrinking margins on consumer and commercial loans. Debt burdens grow heavier as the value of the dollar rises, triggering higher rates of loan defaults and sapping credit demand.
Tim O'Neill, chief economist for Chicago-based Harris Bank, said deflation would curtail new commercial and industrial loan activity as businesses scale back on investments.
"However strong the banks' balance sheets might be, declining consumer spending and declining investment spending clearly mean that companies and households will not be borrowing," he said.
At the same time default rates are rising, the value of the assets securing those loans is falling. That will deepen banks' losses on bad loans.
Not all sectors would be hit as hard. Pharmaceutical concerns such as North Chicago-based Abbott Laboratories, insurers like Northbrook's Allstate Corp. and the area's educational institutions have more leverage to resist downward pricing pressure. Consulting and accounting services likely would not suffer as much from deflation either, as their business and pricing tend to be inelastic and their services in demand in good times and bad, Mr. Miller said.
Area retailers, however, stand to lose big, especially those that sell electronics, clothing and toys — products that consumers can hold off purchasing, waiting for better prices, according to Mr. Tannenbaum. Getting stuck with inventory would force further price cuts and reductions in labor costs.
Property no safe harbor
Real estate values would also slide as more consumers defer buying property and laid-off workers are forced into loan defaults and foreclosures. Deflation would continue to drive rents down, squeezing cash flow to landlords.
Automobile sales, already hurting, would plunge in a deflationary spiral. Chicago, with scores of auto parts suppliers, would be hit hard as inventory piles up and orders for parts and materials all but cease.
Despite the evident perils of deflation, there's little indication that local companies have planned for it. In what might be a sign of corporate denial, nearly all those contacted for this story either didn't return phone calls or declined to discuss the potential impact of deflation on their businesses.
Such reluctance is understandable, considering the general lack of knowledge about an economic phenomenon not seen on a large scale since the 1930s.
"It's very, very hard, because we don't have any experience with this," Mr. Tannenbaum says. "We're all operating in virgin territory — economists, businesses and even the Fed. I'm not sure how we can prepare."
©2003 by Crain Communications Inc. |
