Is the U.S. at Risk of Deflation? Why Lower Prices are Bad for the Economy
Sep 22nd 2010 8:30PM
Updated Sep 23rd 2010 12:08PM
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.