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Deflation

A Dangerous Specter Appears

There are words you don’t ever want to use in polite company, and deflation is one of them. Unfortunately, it’s a serious possibility that we now need to consider.

Yesterday, the Bureau of Labor Statistics reported that the overall level of consumer prices declined by about 1% in October. The so-called “core inflation rate” declined by 0.1%, the first such decline in more than twenty-five years.

(The core rate subtracts out food and energy prices, and is seen as a more stable and relevant price index for policy purposes.)

The biggest declines in October came in prices for apparel, transportation, and energy. But even in the sectors which showed price increases (such as health care and food), the gains were considerably lower than in preceding months.

One month of data does not a trend make, so why am I raising the flag about this? And besides, isn’t it a good thing that we’re all paying less for gasoline?

The problem of deflation in the economy is not a one-month phenomenon. Financial assets (stocks and bonds other than US Treasury bonds) and real estate values have been falling for more than a year now.

The problem with deflation is that it makes the real cost of being in debt far harder to bear. Now you’ve heard me and many others go on and on in recent months about how hard it is for consumers and businesses to get a loan. That speaks to disruptions in the supply of credit, and also to the increased cost of credit intermediation.

But one of the dark clouds in my mind over the last several days has been the other side of the equation. What if some (or much) of the current slowdown in credit formation is due to weak demand for credit?

Many people have made the case that the global economy will recover quickly from the current slump, because as soon as… well, something happens to make credit easier to get, then pent-up business activity will come roaring back. But if demand for credit is impaired as well as supply, the case for a quick recovery becomes much weaker.

And if consumers and businesses have a sense that the real cost of servicing a loan is getting higher, that’s a darned good reason to avoid going into debt. Which in turn means postponing major purchases, hiring, and business expansion.

But what if deflation turns out to be real and sustained? The next danger signal you’d see is a decline in wages. Now we’re already seeing something like that as unemployment ticks up. That’s basically normal for a recession. But what if people who keep their jobs start getting smaller raises, not getting incentive pay, get fewer hours to work, or indeed have to take reductions in pay?

Now you get to the scary part of deflation, because deflation bites everyone that owes money. And millions of Americans have mortgages and student loans on which they pay a fixed amount every month. If your compensation falls (through unemployment, underemployment, or wage reductions), then all of a sudden your mortgage is a lot less affordable, and you’re closer to the point at which you start having to decide whether to buy food, clothing or fuel in any given month.

The cushion in the system which mitigates that possibility is the huge amount of cash currently being held on the balance sheets of large business corporations. They will do everything they can to avoid wage reductions and layoffs. This is a big cushion, and it will last a good long time. Hopefully long enough.

But why are people even considering deflation as a real possibility? Because of the examples of the early years of the Great Depression, and of Japan in the Nineties, after the collapse of their huge real-estate bubble.

That brings us to the possible policy responses to deflation. All we really know for sure is that we don’t want to do what was done in the early 1930s here and in 1994 in Japan. Beyond that, we don’t really know what will prevent a deflation followed by a long period of disappointing growth.

The usual policy response to slowing growth is to cut policy interest rates, and indeed many people now expect the Federal Reserve to cut its key policy rate (the so-called Fed funds target rate) all the way to zero before much longer.

The current Fed funds target rate is 1%, but the actual rate has traded at or below 0.25% nearly every night for the last two weeks or so. (There are some technical reasons for this that I won’t bore you with.) Cutting the policy rate to zero from here will not affect policy strongly enough to give us an economic recovery. In a time of deflation, nominal rates can be zero or even negative, but real rates can still effectively be positive and very high, which discourages business investment.

So what can the Fed do next? It can step up efforts (that it has already quietly started) to perform what’s called “quantitative easing.” Rather than try to indirectly increase the money supply by cutting interest rates, they’ll start increasing it directly. Among other things, they’ll probably start purchasing and monetizing Treasury debt. The last time this was done on a large scale was during World War II and the years immediately following.

But where is all this deflationary pressure coming from?

It’s hopeful to think that we’re seeing normal pressure that comes from an economic slowdown, but there are reasons to believe that there’s more to the picture.

Remember a few months ago, how we were all talking about who was to blame for inflating the housing bubble? And there was a lot of talk about exotic mortgage-backed securities, toxic derivatives created by greedy financiers, and extreme underpricing of all kinds of risk?

Well, even before Barney Frank and Barack Obama can get their hands dirty outlawing all of that innovative (and sometimes dangerous) financial activity, it all pretty much evaporated by itself.

Speaking very broadly, the effect of financial innovation (including engineered financial products) is to increase the supply of capital and to decrease its cost. When you lose financial innovation, that effect reverses.

That’s where the world is today. Financial-market participants and investment professionals have learned a very hard lesson about risk, that they won’t ever want to repeat. Everyone who went through this will be very wary about taking risk for the rest of their careers. And that’s why there is a near-permanent deflationary undertow in the world’s financial system.

The big challenge for policymakers will be to avoid the experience of Japan, in which a severe asset-deflation led to fifteen years of essentially zero growth in economic output and jobs.

In addition to the extraordinary activities by the Fed to increase the size of its balance sheet, there also is the standard Keynesian response of simply building lots of new roads and bridges.

It seems a near-certainty at this point that the new Administration will pursue such stimulating activity on a grand scale.

The Japanese did that too. Didn’t work.

-Francis Cianfrocca

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