by guest contributor Michael Gagnon

A recent front-page headline in the Wall Street Journal stated, “Fed Sees Slower Growth.” According to the article, dated July 14, 2010, “One topic under debate is the possibility that today’s already-low inflation may turn into a debilitating bout of deflation, a broad drop in prices across the economy.”

This concern is being echoed in discussions among economists, policy makers, and the investment community, including the municipal bond market.

It’s not that we haven’t observed deflation in our lifetime. Look at the cost of high- definition televisions, or ask someone who is looking to buy a house whether a dollar can buy more today than it could a few years ago. If deflation is described as a phenomenon that allows a dollar today to buy more in the future (or the direct opposite of the definition of inflation), we have all experienced it in discreet circumstances.

But we have not experienced the deflation of the U.S. economy as a whole since the Great Depression. More importantly, we have not faced the economic response to the perception that deflation is uncontrollable and would only continue to worsen.

Most fixed income financial professionals today can speak authoritatively on “in-flation.” Many remember the high inflation and high unemployment that was prevalent during the late 1970’s. To make matters worse, inflation expectations at the time affected wage demands, which exacerbated inflation levels leading to a new economic term: “stag-flation,” referring to inflation despite high levels of unemployment.

Deflation begins when the supply of money declines relative to the supply of goods and services to consume, thereby increasing the buying power of the consumption dollar.

Increased government spending and wage and price controls did little to solve the problem. The failure of these policies gave way to the perception that inflation was uncontrollable and would only continue to worsen.  Then Paul Volcker was appointed as Chairman of the Federal Reserve with the pledge that he would “break the back of inflation.” In June of 1981, inflation was running at around 10%, down from a peak of over 13%.

But people still lived in fear that it would return and acted under the assumption it would. In this case, the perception was the same as reality. In order to change the market perception, Volcker allowed the Federal Funds rate to reach 20% as a demonstration of his resolve. This was a real interest rate (nominal interest rate – rate of inflation = real interest rate) of roughly 10% that was charged by banks to lend their Federal Reserve deposits to each other overnight. These were fearsome days. Fortunately, we have learned a lot since then. Inflation has subsided dramatically and the general level of interest rates has benefitted. So, what can this experience tell us about dealing with deflation?

Deflation begins when the supply of money declines relative to the supply of goods and services to consume, thereby increasing the buying power of the consumption dollar. If consumption as a whole declines because people embrace the idea that waiting to consume with more valuable dollars always makes sense, that leads to a decline in consumption, which means a decline in production and, ultimately, higher unemployment.  Loss of jobs leads to a further reduction in consumption which only exacerbates the problem. As matters worsen, it could easily lead to the perception that deflation was uncontrollable. And that perception would be difficult to erase.

The obvious response to this problem could be to increase the money supply by lowering interest rates in order to pump money into the system, an activity in which the Federal Reserve is actively engaged presently.  With the Federal Funds Rate target at 0.25%, Ben Bernanke, the current Fed Chairman, seems just as determined to deal with deflation as Paul Volcker was with its mirror opposite 30 years ago. But what happens if the present efforts are not enough? Back in 1981, Volcker could raise rates ad infinitum, if need be, to accomplish his goal. Bernanke is 25 basis points away from 0% for a Fed Funds rate. What happens if that’s not enough to “break the back” of deflation?

Japan, the world’s second largest economy, has been dealing with deflation for the last ten years despite interest rates near zero. The loss in consumption and the high unemployment have been virulent. The stakes are high for the U.S. economy regarding deflation and the consequences are fearsome.

Municipal issuers would have some adjustments to make in a deflationary environment.

Underwriters are always looking for the interest rate that is low enough to satisfy an issuer seeking to pay the least amount of interest, yet high enough to satisfy investors looking for the highest return available. This figure is known as the “market clearing” rate. Success is often found on the margins. Everyone knows what the rough number is likely to be. Active negotiation takes place within the final 10-15 basis points, higher or lower.

The rough number is derived from a combination of fundamental factors such as length of the issue, quality of the issuer’s credit, market conditions at the time, etc. The impact of any of these factors can vary from issue to issue, but one factor is consistent: the allowance for inflation. Regardless of the specific investment, the logic would run, an investor deserves to be paid back in dollars that are equal in value to the dollars invested. Inflation was an economic phenomenon tied to the level of money supply that could affect the value of dollars negatively. Inflation levels could fluctuate over time, but providing a full allowance for inflation was never challenged. Prudent investors had to take its existence into account as best they could when putting their money to work.

So if the yield on a bond was 6% and inflation was measured as 2%, the “real” return was 4% after inflation. In this case, while market participants discussed the nominal rate (6%), it was understood that the haggling began with whether 4% was sufficient after inflation.

When the economy is experiencing de-flation, instead of subtracting the rate of inflation from the nominal interest rate to net the real interest rate, the rate of deflation would be added to the nominal rate to determine that value.

Because an issuer would be paid back in dollars that were more valuable than those it lent out, the market would adjust  by gradually reducing nominal rates so that real rates (nominal interest rate + rate of deflation = real interest rate) would be roughly the same as they are now. This adjustment would result in issuers getting uncommonly low nominal interest rates for their debt.

Reducing nominal rates would win a battle for issuers and still satisfy investors. On the other hand, higher employment and lower consumption could pose even greater economic risk to municipal budgets. Therefore, until deflationary fears subside, the discussion over how to address nominal rates will likely continue.

A deflationary economy could generate a variety of challenges for issuers of municipal bonds. Revenue bond issuers, for example, could feel the effects of a possible reduction in demand for commodities like electricity and water. Sales tax bonds could suffer if consumption decreases.

While future revenue streams could consist of dollars that are actually more valuable than current dollars, the net effect of deflation on municipal bonds can only be determined, at this point, by those with a crystal ball.

Michael Gagnon has been a municipal bond underwriter, trader, and public finance banker in the Chicago area for 35 years.