Ugly or Not, Deflation Rears Head at Auto Industry

By Dale Buss August 23, 2010

No one can agree if it's coming or not. Instead, maybe its opposite will show up. And in any event, the auto industry has been feeling its influence for several years.

large red down arrow.jpgThe subject of this economic riddle?

Deflation.

It's rearing its ugly head, now menacing the economy at large, and already has a strong hold on major sectors such as housing. But a tangible broad-scale appearance of deflation in the U.S. economy could prove a mixed blessing for the American automotive industry.

What It Is, Why Worry About It

Deflation occurs when there is a general cycle of declining economic demand, prices and wages. There clearly are signs of such flattening in the U.S. economy even beyond the huge and consequential swoon in housing and investment values: consumer prices have been flat for three months and hourly wages fell 0.7 percent from the first quarter to the second quarter - including a 2 percent decline in manufacturing wages alone.

Such whiffs of deflation cause confusion, in part, because Americans have had so little experience with it. In Japan, the economy has been mired in an on-again, off-again battle with deflation for the better part of two decades. But in the United States, there hasn't been a major bout of deflation since the early stages of the Great Depression.

loaded car during Great Depression.jpgAnother reason that deflation makes for a murky specter is that there is such vehement and direct disagreement among economists and policymakers about whether we even need to worry about it.

Because of how the U.S. economy seems to be decelerating again, there's no consensus about whether the threat of widespread cyclical deflation is more worrisome than whether the fiscal demands and skyrocketing budget deficits being rung up by the Obama administration - and the concomitant need to print more currency to pay for them - present a greater risk to the economy of inflation rather than of deflation.

Dueling Views

Consider these two diametrically opposed views from seasoned and estimable economists:
Brian Bethune is worried about "deflation in asset values and credit markets." The chief U.S. financial economist of IHS Global Insight, in Lexington, Mass., added that deflation "is a bit like quicksand. Eventually, you'll just be sunk down into a pit. That's why the Fed is trying to inject some cement into the quicksand - to keep us from going into a spiral."

As far as federal budget deficits are concerned, Bethune said, "people [now] want government to be restrained in terms of spending. We're past the whole Keynesian phase, and that's why there is more of an urgency in terms of the Fed doing something to get things rolling in the economy again and help avoid deflation."

David Littman, an economist with the Mackinac Center for Public Policy, Midland, Mich., is far more concerned about the potential for hyperinflation. "We've just had a pause in the acceleration of inflation because of the extent of uncertainty in the economy, both for business investment and people's financial expectations of the future," he said. Instead of deflation, said the former chief economist of Comerica, "We might be on the verge of hyperinflation that could destroy the economy quickly."

The consensus view among automakers seems to be that deflation is a concern - like other key economic factors - but not a worry.

"Some of the latest indicators on inflation showed some moderation below what we would consider a comfort zone," said Ellen Hughes-Cromwick, Ford's chief economist. "We want to recognize the potential risk. But most indicators are suggesting that the U.S. economy continues to grow.

"At present, we're not seeing deflation in our economy. Further, globally we don't see deflation," Hughes-Cromwick said. And if generalized deflation should threaten more overtly, she added, central banks "have a lot of mature knowledge for preventing deflation from taking place."

U.S. Fed Chairman Ben Bernanke certainly has made it clear that he will do everything in his power to stave off deflation.

It's not just professional economists and central bankers whose opinions shape this issue, however. To a certain extent, everyone's sentiment matters.

"One of the important things keeping deflation at bay for the moment is peoples' expectations that it's not yet the most likely outcome," said Dana Johnson, chief economist for Comerica Bank in Chicago. "In wage and price settings, people are operating on the assumption that we'll have low inflation, but not deflation - and that in itself makes the economy less deflation-prone."

Where everyone would like to stay is in something resembling the status quo today.
"Inflation in the range of 1.5 percent to 2.5 percent is the range that policymakers are comfortable with," said Bill Strauss, senior economist and economic adviser for the Federal Reserve District of Chicago. "A little inflation is better than the risk of deflation."

Five Factors To Watch

If low inflation indeed turns into deflation for any length of time, here are major factors that would affect - and be affected by - the auto industry:

The general economic environment: Right now, slowly rising car sales actually are one of the few bright spots in the entire economy. Personal-consumption expenditures have been stronger than before the Great Recession only in the health care, housing and education sectors - each of which has been buttressed by strong federal-government spending, according to Michael Mandel, chief economist of Visible Economy LLC and former chief economist at BusinessWeek magazine (now Bloomberg BusinessWeek).

But if overall deflation becomes part of the current sluggish economic brew that already includes rising unemployment, stagnant retail sales, continued declines in housing prices, and flagging investment values, don't expect the U.S. auto business to remain floating on top of the mess for too long.

Chrysler Pentastar V6 on Trenton, MI, assembly line.jpg"The real problem would be that an auto purchase is one of the most postponable kinds of decisions for individuals and businesses," said Johnson, who served for several years in Detroit when Comerica, now Dallas-based, was headquartered in the Motor City.

Consumers' purchasing power: One direct result of deflation is that the value of consumers' assets declines, and the relative burden of their existing debt increases - both of which make them less credit-worthy and decrease their purchasing power. "Deflation sets up an incentive for households to delay purchases," Johnson said.

Added to the decline in investment assets and lower housing values, potential car buyers simply would have fewer sources of reliable credit to tap - and that would hurt auto sales.

"Deflation just makes people feel poorer," said Sean McAlinden, executive vice president of research and chief economist at the Center for Automotive Research, in Ann Arbor, Mich. "Add that to the fact that workers might be looking at salaries that may not increase for years and mortgages that just get bigger in real terms every year."

Autos as an island of deflation: In reality, vehicles sales in the U.S. have comprised a pocket of deflation for several years now. Real prices on autos have declined an average of 0.4 percent a year for each of the last 10 years, according to the Federal Reserve. In large part, that is due to the industry's productivity gains, which can be expected only to accelerate with labor and overall manufacturing costs coming down significantly.

"The auto industry has been pretty successful in dealing with this, similar to the high-tech sector, where prices fall 10 percent or more a year - yet tech remains one of the real strengths of the U.S. economy," said the Fed's Strauss.

In fact, added Comerica's Johnson, "I don't see how mild deflation would put the auto industry in a very different circumstance than it's already been in for a while. It's been the case for some time that, basically, if you delayed purchasing a car a couple of years, you'd probably end up buying a better car for less money."

Edmunds.com research further particularizes this point. In July, 2002, the average purchase price of a typically equipped vehicle in the U.S. - measured by a proprietary formula called True Market Value -- was $25,430, according to Ivan Drury, a U.S. industry analyst for Edmunds. The TMV figure rose to $29,315 in July of this year.

But adjusting the 2002 price for inflation since then, the same vehicle in 2010 "should have cost" $30,817 in real terms. That means deflation in auto pricing over the last eight years has saved American consumers an average of $1,502 on every vehicle they've purchased.

new-vehicle average TMV 2002-2010 showing deflation.JPGAnd these calculations don't take into account another powerful deflationary dynamic in auto sales over the last several years: advancing technology and content. Nearly every vehicle is more heavily contented and with significantly more advanced features than before, ranging from dashboard electronics to side-curtain air bags - 50 percent to 80 percent more, according to McAlinden.

But automakers aren't able to capitalize on all of the extra content by rolling in price increases.

"We recognize that tracking TMV® minimizes the extent that deflation exists in the auto industry because it doesn't take into account that today's cars have a myriad of features that may not have even existed a decade ago, said Jeremy Anwyl, CEO of Santa Monica, Calif.-based Edmunds.com. "If you look at what you get today, even on an entry level vehicle, it's a staggering amount of value. Vehicles, like computers, just keep getting more advanced for an increasingly better price."

Automaker margins: Regardless of all the above, pricing has increased for new autos in each month since last October, McAlinden said. Used-vehicle prices have surged even more sharply during that period. The recent modest but steady rise in retail demand for vehicles has helped most automakers reduce incentive spending; the domestics are aided particularly by the fact that the yen's high value versus the dollar gives Japanese companies little pricing power with their imports here.

Industry profitability is on the rise again thanks to the removal of labor-related "legacy" costs as well as massive debt reduction by the Big Three. The resulting lower manufacturing costs and tighter control of inventories should lead to better margins for domestic manufacturers. They can make many fewer units than before - and rake in much bigger profits on them.

"If you lower costs, it gives you perhaps more opportunity in the marketplace to be competitive with top-line pricing and to make sure you've got a good margin," said Ford's Hughes-Cromwick.

Yet if deflation curbs price increases on most other goods and services, there will be more pressure on automakers to curb their own prices. Already, McAlinden pointed out, expenditures on internet and mobile-phone services and other electronic utilities are eclipsing car-payment amounts in many households.

Autos could become comparatively expensive as sellers are forced to discount all manner of other retail items, McAlinden said. "If prices keep falling everywhere else and autos maintain their discipline, sales won't improve. We could be stuck at [sales of] 12 million [units annually] for another year or two."

Cash for Clunkers car - 255.JPGMoreover, if deflation removes low-interest-rate loans from automakers' toolbag - because of the expectation that cars would be only less expensive in the future - they might have to return to hefty cash rebates to move the metal.

"That would mark the return of a marketing strategy that was enormously destructive to the Big Three in particular," said Eli Lehrer, director of the Center for Finance, Insurance and Real Estate at the Heartland Institute, in Washington, D.C.

Squeezed suppliers: The OEMs and several major suppliers have drastically reduced their indebtedness compared with before the Great Recession through conventional pay-downs, bankruptcies and federal bailouts. Still, huge debt levels remain a pressing issue for some suppliers.

"They still have to pay those debts back," said Scott Eisenberg, managing partner in the Detroit office of IMAP, a global mergers and acquisitions advisory firm. "And with deflation, they could have a 95-cent dollar to pay it back with."

Deleveraging their balance sheets has been a top priority of automotive suppliers for some time, of course, and most large suppliers have been "renegotiating as much of their debt as they possibly can," said Dave Andrea, senior vice president of industry analysis for the Original Equipment Suppliers Association, a trade group based in Troy, Mich.

"But the suppliers who could potentially get caught more in that situation would be small suppliers."

Still, Andrea said, what suppliers are more concerned about is getting caught between falling prices for the vehicles sold by their end customers - which would reduce suppliers' own top lines - and rising prices for commodities beneath them.

"With the emerging economies in China and India, you have price inflation on the input side," he said. "That could squeeze margins for suppliers without any positive bump from sales volumes if there is deflation in U.S. retail [vehicle] prices."

These are just some of the major complications for one sector - albeit an important one - of the U.S. economy from the onset of generalized deflation. They illustrate why so many people with a lever on the economy want to keep deflation at bay.

"The Fed is trying to get us back into the gravitational pull of the earth, to a more normal state of affairs," said IHS's Bethune. "So far, it's a struggle."

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LEAVE A COMMENT

myob says: 7:06 AM, 09.05.10

I think we need to be careful about using the terms inflation and deflation. They are not the same thing as relative increases and decreases of the price of various things in the economy. Home prices are falling due to oversupply. That is not "deflation". There are more cars than needed, less demand for new ones, so prices will remain relatively lower. This is not "deflation".

Inflation/Deflation refer to the money supply, and they have an effect on prices. They do not effect all prices similarly. For example, we may see "inflation" in gasoline prices (necessary) and "deflation" in the price of collectible baseball cards (a frivolous luxury)

People do not "need" $30K plus autos. So therefore prices for them will be dampened. There are tons of used cars available in good shape for under $30K. Therefore they will buy used rather than pay more for a new car. Pretty simple stuff really. We're poorer as a nation, so we will buy less expensive stuff, like poor people always do.

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