Deflation: Prices trend downward

The Concept of True Inflation

Let's use a simplified example to think about this concept.  If a Corvette sports car cost $5,000 in 1965 and $50,000 in 2000, has the price gone up?  This must be summarily evaluated from two perspectives:  1.) absolute dollars, and 2.) utility for the user.

True Inflation = Deflator( C^Ad )  X  [ 1 / Utility ]

C^Ad   represents the cost of the nominally same product or service measured in absolute dollars.

Deflator represents the factor derived from a fixed, wide-ranged basket representing all goods and services purchased by the typical consumer.

Utility represents the functional value to the final consumer.  When utility is constant it is defined as having a value of 1.000.  If utility at the end of an interval is greater than at a previous checkpoint, it is defined as >1.  If utility at the end of an interval is less than at a previous checkpoint, it is defined as <1.

Back to our sample question.  If our basket of all goods and services tells us that a 1965 dollar is worth $0.10 today, it will require $10 to purchase the same item today as we might have purchased with our dime in 1965.   This valuation for the deflator is approximate, but let's accept it for this example.

Looking at the cost of our Corvette, it appears that it has not changed in price from 1965 to 2000.  A 2000 Corvette costs the same as a 1965 Corvette cost new.  The calculation is:

Deflator(C^Ad) or 10($5,000) = $50,000

Now we must evaluate the Utility factor of the above equation.  This has two components:  1.) Subjective Utility, or consumer appeal, and 2.) Functional Differentiation Utility, or the new or deleted operating functions.

In our example, the subjective utility is personal and will vary in ethereal ways with different people.  Let's assume for this example that it is just as much fun for the driver today as it was (or would have been) in 1965.

That leaves functional differentiation to calculate.   This is objective and often more accurately quantifiable.  For example, today's Corvette has power windows, steering, brakes, 6-speed transmission, and is more fuel efficient than our 1965 Corvette.  We can assign values to the similar and newly invented features.  Let's say that power windows are ranked 4 while crank windows are ranked 2.  Therefore, window utility is double on the 2000 Corvette what it is on the 1965 Corvette.  If, for this example we use only this change of Functional Differentiation Utility, we have the following:

Utility or 1/(1/2) = 2

Utility has doubled from 1965 to 2000.  Now to complete the calculation of inflation in the True Inflation of a Corvette from 1965 to 200 is:

True Inflation = Deflator(C^Ad)   X  [1 / Utility]

= 10($5,000)  X  [1/2]   =  $25,000

Or, in True Inflation terms, the 2000 Corvette costs half as much as the 1965 Corvette!  To have meaning beyond the example, this calculation should include major functional and operational changes.

This calculation quantifies a portion of the real world that consumers live in, but if we remain healthy, held a job and worked our wages to higher levels, we can really enjoy our new Corvette and afford to pay for it.  A standout aspect of this example is the importance of technology and the ability of technicians to build it into new consumer goods.

As of 2003, inflation has eroded the purchasing power of the 1982-1984 dollar to 57.9 cents and the 1967 dollar to 19.3 cents.

Inflation started in all seriousness and with ferocity in 1971.

Logically what is next?  Choices include continued inflation, general price stability, and deflation.

Does an adjustment to the recent (decades-long) inflation make sense?  Quite probably yes.  Since deflation is an adjustment, deflation is a most probable expectation.

Add to this plausible and logical conclusion these factors that contribute at any time to downward pressure, even during an inflationary phase:

1.)  Psychology of recession with its fears and lackluster consumer excitement toward purchasing goods and services;

2.)  The War Against Terrorism;

3.)  Work force shrinkage (job cutting) in both goods and service industries.

These three factors contribute in an additive manner toward more people having less disposable income today than they had yesterday... and they will have even less discretionary money tomorrow.

The fourth factor is momentous and deserves a stand-alone comment.  That factor is the decreasing demand for commercial real estate over the foreseeable future.

Firstly, manufacturing facilities are in surplus today and with capital expenditures not increasing, the need for new manufacturing floor space will not exist.

Secondly, the need for office space which is already in surplus, is and will continue to suffer from the following factors.

1.)  Technology has reduced the need for people to sit in common offices and at the same conference tables;

2.)  Cultural shifts have reduced people's desires to attend large office and industry conferences;

3.)  The psychology and reality of terrorism creates underlying management thinking that it should attempt to distribute workers if operationally feasible.  Note that technology makes it possible when operationally feasible.

But more importantly, the reality of terrorism demands that prudent management distribute personnel when it is operationally feasible.   Simply put, it is not wise to concentrate all staff and management resources in one location when terrorism is lurking about.

Therefore, the need and demand for office space will continue to decline.

Analysis of price trends, their directions and magnitudes, include only three possibilities:  1.) Prices trend up, inflation;  2.)  Prices trend down, deflation; and, Prices trend on a net zero curve.  Possibilities 1 and 2 have associated magnitudes whose use must include numbers in order to reasonably quantify specific phenomena.

To start forming your understanding of what the longer term price trend currently is, ask yourself the following question.

When you wonder if there is a meaningful chance that deflation might erupt in an uncontrollable fashion as inflation did during the 1970's, ask yourself, "Was the possibility of problematic, long-term inflation being discussed in the early 1970's?"  Note:  The macro inflationary phase that ended in 2000 started in 1971.

If you want to gain an understanding of today's price trend, leave your charts, government reports and suppositions in your desk drawer.   Go to retail stores of all types, watch people's buying and rejection processes, and think about the quality and features of products.  Consider the quality and range of services available.  Watch industrial products in industries you are familiar with for implementation of new technologies, labor changes and raw material costs.   Compare your collected observations with your knowledge of the past at critical reference points.  Some critical reference points are 1971, 1980, 1994, and 1999.

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