Fear of Falling Prices

Anxiety over deflation is wide-spread and increasing.  The New York Times lead editorial on Sunday warned that weakening commodity prices may be a harbinger deflation or a hint of economic decline.   Despite a few contrary voices, both policy makers and investors seem concerned.  Are the fears misplaced? Or would deflation be a large step backward?


The chart shows 101 years of American inflation measured by the CPI.

Prices move all the time – not just stock prices but prices of almost everything in the economy. Deflation is when prices, usually measured by an index like the CPI, consistently fall.  Inflation is the opposite, prices rise. Largely, but not completely, inflation and deflation are mirror images of one-another; for now call them flation.  If flation’s movements aren’t too sudden, surprising or violent and if everyone anticipates them, the damage would be minimal.  Anticipation is important because financial contracts often specify payments made over time and rarely adjust the payments for flation.  When prices rise, goods and services cost more but money is worth less; in deflation prices fall, goods and services cost less and money is worth more.  If everyone expected 5% inflation and all existing and future loans, bonds, contracts and agreements reflected 5% inflation – and the prediction came true – no one would be hurt by inflation.  Bond holders and other lenders would be compensated for the falling value of money with higher interest rates.  Prices and wages would smoothly adjust.  For a visitor from a foreign country with stable prices the only hints that things were different would be seemingly high nominal interest rates and a falling currency.   Of course this no-pain world of 5% inflation cannot exist – inflation expectations won’t be universal, predictions won’t always come true, prices will depart from their expected path and policy makers will keep changing the game plan.

There are some differences between deflation and inflation. An economy of fully anticipated deflation would be worse than one of anticipated inflation.  First, interest rates can’t go below zero – if some tells you that if you deposit money in a bank, the bank will pay you -5% interest — take 5% of your money and not give you anything in return – you’ll hold on to your cash. Suppose prices are falling 5% per year and government bonds pay 1%. The deflation-adjusted return on the bond is 6% and it is risk free.  Risky investments don’t look very attractive when the risk free real rate of return is boosted by deflation.   Deflation at 1% or 2% might not be a huge impediment to investing, but flation is rarely stable. As investment dries up and the economy slumps, 2% deflation will become 4% or 6% or more.  When prices fall, the best investment is often holding on to your money – its works best by not working at all.

Business faces problems in deflation – as the prices a company receives for its products or services decline, it will try to pay less for everything  – materials, office space, capital and people.  Renters will pressure landlords to lower rents, forcing down real estate values. If capital means bonds, business may face high real rates of interest if bonds were issued before prices began to fall. The it is equity capital, dividends are more expensive. Companies will cut wages and salaries; or, fearing that the best people may leave, will lay off workers.  Were prices slowly rising rather than falling, companies would be able to raise wages and salaries by roughly the same proportion as the inflation rate without paying significantly more in inflation-adjusted wages.

These two factors – that interest rates cannot fall below zero and that people can accept a little bit of inflation with some money illusion – mean that moderate inflation is workable while moderate deflation is not.  For either flation there is a large danger – as the rate expands, it becomes more volatile, less predictable and more damaging.  That is why central banks were so proud of keeping inflation low in the 1980s and 1990s.

With prices rising less than 2% in the US, less than 1% in Europe and oil plunging by 20% since July, should we worry?  The oil price plunge is a different story. While it does contribute to lower prices across the global economy, the drop in oil prices stems from new supply and the structure of the oil markets.  The miniscule increases in prices, much below current policy targets, are a symptom of an economy where demand is growing more slowly than potential supply.  In Europe, the US and Japan, there is sufficient underutilized labor and capital to support faster growth. Slowing or falling prices mean that people, business and government, out of either fear or risk aversion, prefers to hold on to its money rather than spending it. There is room to grow, we just need the right policy to get it started.

The posts on this blog are opinions, not advice. Please read our disclaimers.

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