Is the U.S. at Risk of Deflation? Why Lower Prices are Bad for the Economy

Consumer prices are climbing, but not fast enough to keep the Fed from worrying about the possibility of economy-damaging deflation.It might seem like prices are rising wherever you look, from medical care to college tuition. Yet to the Federal Reserve, they might not be going up fast enough.

The Fed says a little more inflation might be just the thing to start a chain reaction that would ultimately create jobs - and avoid a spiral of falling prices that could damage the economy.

In a statement Tuesday, the Fed avoided directly mentioning the dreaded word "deflation." But it signaled its concern that today's very low inflation might lead to actual price drops.

The Fed, meeting for the last time before the midterm elections, said its measures show inflation is "somewhat below" desirable levels for the economy. That may sound strange, because inflation is often made out to be an economic evil.

And it can be, when it gets out of control. But its opposite can be even worse.

Why Deflation is Bad

Once deflation takes hold, it can wreck an economy. Workers suffer pay cuts. Corporate profits shrivel. Stock values fall. People, businesses and the government find it costlier to pare debt. Foreclosures and bankruptcies rise.

And people spend less, convinced that prices will fall even further if they just wait. That trend has already emerged in the housing market. Many would-be buyers are standing on the sidelines, waiting for home prices to fall further.

Spending by shoppers accounts for about 70% of economic activity in the United States. A further drop in their spending could potentially throw the economy back into recession.

It's true that the costs of items like health care, education and transportation have surged. But the Fed studies a wide range of prices across the economy. Overall consumer prices - excluding food and energy prices, which are volatile - inched up just 0.9% for the 12 months that ended in August. That matched a 44-year low, according to the government.

And it's well below the Fed's comfort zone for inflation, which ranges between 1.5% and 2% over a year. The Fed would like to see inflation at least that high because it would show the economy is making a solid recovery. It would mean shoppers are confident enough to spend and businesses confident enough in customer demand to raise prices. Confident employers are more likely to create jobs.

What the Fed Can Do

Right now, prices are relatively low because the economy is still so weak. Companies can't raise prices because high unemployment and scant pay gains are making shoppers cautious. Companies have to resort to discounts and promotions to entice them.

The Fed's statement Tuesday made clear that it's prepared to intervene to prevent deflation. One way would be to make big purchases of government bonds to drive down long-term interest rates. That could help stimulate borrowing and spending.

"The average person may be bewildered by the Fed's concern about deflation," said Allen Sinai, chief economist at Decision Economics. "But part of its job is to be educational. The Fed wants people to know it is not going to let this rare disease happen."

And spreading more confidence among consumers and businesses would reduce the likelihood of a deflationary spiral, Sinai said.

The Risk of Fighting Deflation

The last time the country endured a destabilizing case of deflation was during the Great Depression of the 1930s. Japan suffered what's often called a "lost decade" in the 1990s after a financial crisis led to deflation and economic stagnation.

When deflation strikes, it's hard to embolden consumers and businesses to spend. Japan is still fighting deflation even as it has kept its key short-term interest rates near zero, as the Fed has for nearly two years. Low rates are supposed to help neutralize deflation by spurring people to borrow and buy things. Yet so far, the Fed's ultra-low rates have failed to rejuvenate the economy.

The Fed signaled this week that it's prepared to act if the economy worsens, and its next likely line of attack would be to flood more money into the economy by buying Treasury bonds.

Yet deflation-fighting moves carry their own risks. Super-low rates lead to speculative buying, creating dangerous bubbles in the prices of bonds, commodities or other assets.

A long period of super-low rates after the 2001 recession helped feed a housing bubble that burst and led to the 2007-2009 recession.


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bohemianacres

The common folk have caught on to all this willy-nilly spending and crediting up to the hair line. It is a bunch of hooie. We have learned what is important and are spending accordingly. Why go into another deflation-preventing scheme only to have another recession. Oh, yes, we are being educated. But it is not the way the fat cats and government with all their taxation want it to go so they can tax and spend somemore. Bring on deflation. I can live on bread and water for another two or three years. This recession already feels like a prison sentence already. Prisoners do not spend either. What is the difference.

September 23 2010 at 11:38 AM Report abuse +2 rate up rate down Reply
George

Who wrote this load of BS??!! Inflation is caused by Govt/FRB/fiat CREDIT based money. If the GOVT/FRB did not INFLATE the money supply prices would stay flat or go down due to productivity; and wages would only go up when us workers do more valuable work. No one should be paid more next year for the SAME work done this year.

September 23 2010 at 11:24 AM Report abuse +2 rate up rate down Reply
thedtecter

Duh, precisely why the FED and fiscal policy is to manage FOR inflation instead of to manage to control inflation. Without inflation everything hedged on the future is worthless. Low prices are BAD for the economy? Only if the government is trying to keep the economy propped up to an artificial level, a strategy that cannot be sustained. If the government would have let the market fall to take a full correction 18 months ago our money system would have reset itself but then too many big players and the elected officials they control would also have lost big time.

September 23 2010 at 10:32 AM Report abuse +3 rate up rate down Reply
Robert & Lisa

The thing to restart our economic engines is to cut government spending and regulations in half. Notice, I don't say do away with them, but cut them in half.

September 23 2010 at 10:05 AM Report abuse +2 rate up rate down Reply
sjoberdix

We the people have to accept 1970 wages then wallstreet has to accept the prices that go along with the wage earnings. Since they say the price increase is due to what we make.Now that the overhead is gone the price is not needed.

September 23 2010 at 7:46 AM Report abuse rate up rate down Reply
liahi4u

Its about time prices were adjusted to what they should be. All those house prices were totaly out of whack. People thinking they could afford what they could not. i still see 3 SUV's in a lot of driveways.

September 23 2010 at 5:59 AM Report abuse +1 rate up rate down Reply
hello

Appropriate that there is no name attached to this article. By "educational" they mean "what other words,phrases and names can we throw around that will make it easier for us to rob and swindle the public outright that it won't sound like highway robbery". Consumer spending is still around 70% GDP before the depression and at this very moment. What has changed is domestic investment. That is what is down. That is what is needed. And for that to happen the biggest choke hold on the economy has to be removed-government. Government with it's hair-brain ideas of 'free health care',a job and house for every man,woman and child,'free indoctrination(sorry,the elites like to call that 'education' just like they like to call deflation a disease).

September 23 2010 at 3:24 AM Report abuse +3 rate up rate down Reply