Friday, November 21, 2008

Should We Be Worried About Deflation?

We're used to low and stable inflation in the United States—a slow, but steady increase in the prices of goods and services over time. The inflation rate measures the pace at which prices rise over time. The table below shows the CPI (consumer price index)—which measures the average price of a representative basket of consumer goods and services—from July to October in 2007 and 2008, as well as the annual inflation rate. In recent months, the U.S. economy experienced disinflation—the annual inflation rate, while positive, declined from a peak of 5.6% in July to 3.7% in October. The CPI continues to rise year-on-year, but it's doing so at a slower and slower pace.

Notice that the CPI declined significantly in October 2008 (from 218.8 in Sep '08 to 216.6 in Oct '08). In fact, the 1% decrease in consumer prices during October 2008 was the largest one month decline in 61 years. The sharp month-on-month decline in prices raised some fear of deflation. Deflation occurs when the prices of goods and services fall over time. Persistent deflation leads to negative annual inflation rates.

A sharp reduction in total spending by businesses and consumers typically precedes an overall drop in prices. For deflation to persist, business and consumer expectations must adjust. If people expect prices to continue falling, they will postpone purchases. Why buy today what can be obtained more cheaply tomorrow? The postponed spending reduces the current demand for goods and services. With weaker demand, prices fall even further and firms begin to cut back on production and lay off workers. Should we be concerned about this type of deflationary spiral?

Exploring the difference between headline and core inflation can help us answer this question. Headline inflation, reported in the table above, measures changes in all consumer prices. Core inflation measures changes in the CPI excluding food and energy prices. Since food and energy prices tend to be volatile compared to other prices, removing them from the CPI can allow economists to obtain a less distorted view of the inflation trend. The core inflation picture for October 2008 is far less alarming—the CPI less food and energy prices barely registered a change.

Falling energy prices were the primary cause of headline deflation in the month of October. A decrease in the relative price of energy is not necessarily a bad thing. A good's relative price is measured in physical units. Suppose that, in May 2008, the price of gas was $4 per gallon and the price of a movie ticket was $8. To express the relative price of gas in May 2008, we'd say that one gallon of gas cost one-half of a movie ticket. If, in October 2008, gas is down to $2 per gallon but movie tickets still cost $8, we'd say that the relative price of gas is one-quarter of a movie ticket. In other words, gas has become relatively cheaper since energy prices are falling as other prices remain largely the same.

Nobody's complaining about relatively inexpensive gas. Declining energy prices will likely feed through to the prices of other goods and services in the coming months. We may even see a negative year-on-year inflation rate. But a damaging deflationary spiral still seems like a remote possibility. Only when consumers and businesses begin to build expectations of falling prices into their decisions will deflation become a real threat.

Discussion Questions

1. Deflation presents big problems for debtors. Recall that the real interest rate a borrow pays on a loan is equal to the nominal interest rate minus the inflation rate. If you take out a fixed rate loan with a nominal rate of 8% and expected inflation of 2%, you'd expect to pay a real rate of 6%. What happens to your real rate if falling prices push the actual inflation rate to -1%?

2. What would deflation do to the purchasing power of a debtor's principal balance? For instance, how would persistent deflation affect people's ability to repay home loans? How would it affect the already beleaguered housing market?

3. If the Fed fears persistent deflation, what policies should it pursue to ensure that deflationary expectations do not develop? What are the risks associated with anti-deflationary monetary policy? How could government fiscal policy assist the Fed in preventing deflation?

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