2004-04-15 / Business & Finance

Taking A Closer Look At Deflation

Taking A Closer Look At Deflation

Most people alive today worry about inflation, not deflation. Why? Because deflation hasn’t happened since the Great Depression. If you were an adult during the Great Depression, that would make you 90+ years old!

Most of us have grown up during decades of rising, not falling, prices. We’ve worked, saved, and invested so that, hopefully, we can maintain a certain standard of living despite a de-cline in the purchasing power of the dollar.

Now, Just when we thought we un-derstood inflation, and had it reasonably under control, along comes its infamous evil twin, deflation. Of late, we’ve been bombarded with a steady stream of articles and reports (writers have to make a living) on how deflation might be an even worse threat than inflation.

Deflation has a death grip on Japan’s economy. Japanese investors have been decimated. The Nikkei index, Ja-pan’s equivalent of the Standard & Poor’s 500, which peaked at over 40,000 in the late 1980’s, now stands at about 8,500. It’s down almost thirty percent in the past twelve months. How would you feel if the S & P was still down 75% from its 2000 highs fifteen years from now?

Since most of us really don’t know much about deflation, let alone have any experience dealing with it, let’s take a look at it.

A definition of deflation says, "A decline in general price levels, often caused by a reduction in the supply of money or credit. Deflation has often had the side effect of increasing unemployment in an economy, since the process often leads to a lower level of demand in the economy. Opposite of inflation."

Clear? Probably not. It is simpler to think of deflation as an extended period of falling prices, just as we think of inflation as being a period when prices rise.

What’s the difference between "de-flation" and "disinflation"?

Disinflation is something we’ve gen-erally been happy about; it’s a fall in the rate of inflation. For example, core inflation in the U. S. averaged about 2.7% in 2001, but has fallen to about 2% in recent months—a period of disinflation. We still have inflation, only less of it.

Deflation, on the other hand, is a broad-based decline in the price of goods and services a negative rate of inflation. In Japan, for example, prices have fallen on average about 1% each year since 1995.

How do we measure inflation? There are lots of different indicators, but the simplest and best known are the Con-sumer Price Index (CPI) and the Pro-ducer Price Index (PPI), put out monthly by the Bureau of Labor Statistics.

Some of us can recall the extreme case of inflation in the late 1970s and early 1980s. It was a time when homeowners jumped at a 15% mortgage rate because in a month it might be 16%! Today, our concern is that the "real" rate of inflation may become negative, or, in other words, deflation.

What danger does that pose for the U. S. economy? Well, of late consumer spending has made up more than two-thirds of overall U. S. economic activity. With business waiting on the sidelines, consumers are keeping the economy moving, albeit slowly, but moving nonetheless.

What would happen if consumers stopped spending, or even slowed their spending significantly? The economy would go into a tailspin, GDP growth would collapse, and unemployment would likely skyrocket.

Historically, most of us have been worried about rising prices. That meant that when we had money to spend, we would do so immediately because of our concern that future prices would be higher.But, what would you do if you thought future prices would be lower, not higher? You’d probably post-pone your buying in the hopes that prices would come down. If a lot of people thought that way, consumer spending would decline, leading to further price declines and further postponement of consumption. The "death spiral" would begin!

What can we do to prevent it? The Federal Reserve is already working hard through monetary policy to prevent deflation from taking hold by lowering interest rates and increasing the money supply. Hopefully, that will en-courage consumers to keep spending and eventually prod business into more capital investment.

But, monetary policy has its limits. The Fed can’t push interest rates be-low zero, and near zero rates haven’t kept Japan from the throes of deflation for the past several years.

Tax policy and government spending are two other tools to combat de-flation. Cutting taxes gives consumers more money to spend and may make them feel more financially secure. In-creased spending by the government also helps to keep deflation at bay. However, as it has in the US at this time, it may also lead to large government deficits.

If it does occur, how can we cure it? In addition to lowering interest rates, the Treasury would likely expand the money supply at an even faster rate i.e., printing more money. The Fed could purchase more government bonds and even consider buying corporate bonds. Another strategy would be to purchase foreign currencies, which would weaken the dollar.

Whew, this is scary stuff. Let’s hope it doesn’t happen.

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