Deflation in full swing

2008's economy can be divided into two parts. The first is the period between January and July when oil prices ran up to $147 thanks to a speculative trade to short the dollar and buy oil and other commodities. The second part is the post oil's July peak where oil prices have featured a 60% to $55. Today's wholesale price report shows what happens to prices when supply exceeds demand and banks stop lending money to traders trying to profit from anticipated inflation.

Today's wholesale price report is a doozy. The Producer Price Index (PPI) fell 2.8% in October -- much more than the 1.8% decline economists had anticipated. The PPI decline was fueled (pun intended) by a 12.8% decline in energy prices in October. And as long as those energy prices keep falling, inflation will be in full downswing mode. (I am happy to report that I won my bet that gasoline would drop below $1.99 a gallon in Eastern Massachusetts by February -- I went to a station Sunday that charged $1.97.)

But there's more to it than simply declining oil prices. The entire economy was producing goods and services based on an assumption about demand that depended on easy access to debt. By shutting off the debt flow, goods are simply too expensive for consumers and businesses to pay the price. This means businesses will cut back on production and slash prices to clear their shelves of inventory. Then they'll shut down factories and lay off workers. And the lower demand from those poorer former workers will start the cycle anew.

Peter Cohan is president of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter.