Monday, October 20, 2014

Why deflation is so scary

Comparison shopping                        

If the price of a car or an iPhone drops, that’s usually good news for consumers. So it might be puzzling that investors and economists suddenly seem freaked out about the possibility of deflation, or a sustained drop in the level of all prices, on average.

Deflation was a concern back in 2010 and it’s a fresh worry now as oil prices plunge, the stock market wavers and consumers put spending plans on hold.

The paradox of deflation is that falling prices on a few items can generally be good for consumers, leaving more money in their pockets for other things. But falling prices on too many things can have ruinous effects on the economy that are hard to reverse. Japan suffered nearly two decades of deflation starting in the early 1990s, and deflation helped prolong the Great Depression in the 1930s.

When all prices fall, consumers have a strong incentive to put off purchases -- after all, everything will probably be cheaper tomorrow. Some purchases are hard to delay—food, medical care, gasoline to get to work. But a lot of the things we buy can wait, which is why sales of cars, clothing, and appliances drop sharply when times get tough.

In an economy like ours — in which consumer spending accounts for about 70% of total GDP — a powerful incentive to postpone purchases can be disastrous. When spending drops, so does corporate revenue, raising pressure to cut costs, which leads to layoffs and other personnel cutbacks. Companies are likely to freeze salaries or even cut pay for those workers remaining. Dwindling income makes consumers even more leery about spending money, worsening the whole cycle.

More expensive debt
The other mechanism for deflationary ruin is debt. One big reason lending helps the economy grow is inflation—most loans become easier to pay back over time, because the principal doesn’t grow but income used to pay it down does. We typically think of inflation as a rise in prices, but it's usually accompanied by an increase in workers' wages as well, and as long as wage increases exceed price hikes, ordinary people get ahead. Home buyers, for instance, often “grow into” a mortgage that might seem onerous at first, because their income climbs as they progress through their careers. The mortgage payments on a fixed-rate loan, by contrast, remain constant. So in a typical economic environment, you gradually earn more income to make the same payment every month.

Deflation creates the opposite phenomenon: Debt gets more expensive over time, because consumer spending power declines. When prices and corporate revenue fall for a sustained period of time, wages inevitably go down, too. That makes fixed-rate debt more expensive, because you have less money instead of more to make the same regular payments. The mismatch affects companies and even governments the same way it does consumers, causing cash-flow shortages, liquidity problems and bankruptcy. Each of these ugly outcomes reinforces the others, making a deflationary spiral very hard to pull out of.

On top of that, deflation makes people wary of taking out debt in the first place. Too much debt is a problem in itself, but prudent lending is an essential element of capitalism. Without it, investment shrivels and wealth is more likely to disappear than accrue. 

We don’t have deflation yet, but we may be in a period of "disinflation," in which prices rise but at a progressively lower rate. The U.S. inflation rate dropped from 2% in July to 1.7% in August and will probably come in lower during the rest of the year, if only because plunging oil prices will lower the cost of gasoline and other products affected by petroleum or energy costs. This chart tracks the monthly inflation rate during the last five years:
View photo
Source: Moody's Analytics.
Source: Moody's Analytics.

Will central banks respond?

The risk of deflation is greater in Europe—where inflation is just 0.3% (a five-year low) and the economy is weaker than in the United States. Disinflation (though not deflation) may also be taking hold in Japan and China.

Lower inflation abroad will reduce prices for U.S. imports, as will a strengthening dollar, which has occurred as investors have chosen to put more money into U.S. assets and less into foreign ones. All of those factors contribute to disinflation and could generate outright deflation if they become severe enough. As the chart above shows, however, disinflation doesn't always lead to deflation; the rate of inflation dropped in late 2011 and early 2012, but then leveled out around 1.5%. 

The Federal Reserve has been determined to head off deflation, which is one of the rationales behind the super-easy monetary policy that began in 2009. Part of that policy—quantitative easing—ends this month, which may be one of the factors shaking up markets. It seems unlikely the Fed will restart QE, although one key Fed official, James Bullard, recently argued the Fed should keep QE going. His case would get stronger if deflation seemed imminent. Under QE, the Fed pumps money into the economy by buying bonds, which in theory ought to make borrowing cheaper, lubricate consumer spending and potentially cause inflation. But many predictions of runaway inflation have been way off the mark, with deflation concerns today undermining how weak the global economy really is.

A more likely source of quantitative easing may be the European Central Bank, which has long hinted at aggressive stimulus measures but acted more modestly, to appease inflation worrywarts in Germany and elsewhere. Near-zero inflation—or full-blown deflation, if it happens—may finally prompt the ECB to mimic the bolder moves of the Fed. Meanwhile, if you see a good deal on a phone or an SUV, consider whether you can get a better deal by waiting. If you think you can, we may all be in trouble.

Rick Newman’s latest book is Rebounders: How Winners Pivot From Setback To Success. Follow him on Twitter: @rickjnewman.

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