January 11, 1999

Once concerned with government deficit spending, rising inflation, tax system overhaul or any of an array of other looming dangers, money managers and investors in general have found new bogeymen to fear: deflation and lack of pricing power. The reasons for their fear are the flip side of the debate we had a while back when people were worried that strong real GDP growth would lead to accelerating inflation. The deflation/inflation argument is an outgrowth of the Keynesian framework that gave us the Phillips Curve--the famous relationship showing that for higher output, an economy must endure higher inflation. In theory, the dynamics of the relationship say that strong growth leads to increased demand for individual products and, given an upward-sloping supply curve, supply bottlenecks would develop, resulting in higher marginal production costs. So that, part of an increase in demand is satisfied through higher prices. The greater the level of production, the steeper the increase in marginal costs. Aggregating this phenomenon across industries, the net result is a higher price level--higher inflation. Conversely, aneconomic slowdown leads to declining pricing power and, as a consequence, to a decline in prices--or deflationary pressures.

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