Talk of deflation is just hot air

January 24, 2002

By James W. Coons

The recent swoon in inflation is good news as long as it lasts. And a resurgence in inflation is more likely than descent into destructive deflation.

Consumer prices fell in December, after holding steady in November and falling in October. The three-month decline from September to December was the first since the spring of 1986, when oil prices collapsed. Before that, consumer prices had not fallen over a three-month span since 1954.

The declines are especially pronounced in some segments of the economy. Prices of consumer goods have declined in six of the last seven months, and are 1.5% lower than a year ago. At the wholesale level, prices fell at an annual rate of 6% in the second half of the year.

An unrelenting, broad-based price decline is no small evil. Unchecked deflation destroys producers’ will to produce and consumers’ will to consume. When consumers expect prices to fall, they postpone purchases to get a lower price. Producers are reluctant to purchase materials that will fall in value by the time they are assembled and shipped.

At even a modest rate, deflation substantially increases the real burden of debt. Deflation eventually forces employers to reduce the wages and salaries out of which workers are repaying fixed loan amounts. Defaults and bankruptcies multiply in response. Economic decay cumulates as people try to sell assets to repay loans, further depressing prices.

These painful events were last witnessed on a widespread scale in the United States in the 1930s. More recently, the New England economy suffered a narrow form of debt-deflation a dozen years ago, as thousands of homeowners walked away from houses, the values of which had fallen below mortgage balances.

We should not take deflation lightly, for it is a seriously destructive economic disease. But neither should we fear deflation unnecessarily. The recent decline in wholesale and retail prices is mostly the temporary result of presumably welcome declines in energy prices. Little more than a year ago, the run-up in oil prices was economic enemy number one.

The key to understanding why the recent spate of price declines is benign is that true deflation is a sustained decline in the general level of prices. Not a brief decline. Not a decline in just some prices. The current mini-bout of falling prices does not qualify.

Think of the economy as a ham sandwich. Even a big decline in the price of ham does not represent deflation if the prices of wheat and cheese rise. The fortunes of pig farmers, wheat farmers, and dairy farmers differ, but the general level of prices need not fall.

Similarly, increases in some prices are still offsetting decreases in other prices in the real economy. The so-called core rate of inflation, which excludes prices of food and energy, continues to chug along at 2½% to 3%. The Consumer Price Index for services, on which consumers spend 58 cents out of every dollar, increased 3.6% last year. Excluding the unsustainable drop in energy prices, the CPI for services increased 3.9%.

Looking ahead, it is more likely that inflation will rise than give way to deflation. Many market-based leading indicators point toward lower inflation, but they look out only so far and are not infallible. Ultimately, monetary policy determines the path of the general price level. And over time, growth in the broad money supply is a reliable measure of monetary policy.

The implication of recent research at the Federal Reserve Bank of Cleveland is that the 10% increase last year in the quantity of readily spendable money, if sustained for another three years, would almost certainly pump up inflation significantly.

The point is not that the economy is in imminent danger of a serious rise in inflation. It is merely that higher inflation is more likely than deflation, given the current stance of monetary policy. And if this assessment proves wrong, Greenspan & Company will quickly administer a massive dose of easy money – a sure cure for a falling price level. No matter how you look at it, talk of deflation just so much hot air.

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