Events of recent weeks have forced economists to blow the dust off some old concepts that most of us have not given much thought to during our lifetimes. One such topic is deflation, a general decline in prices. Any form of price instability is bad for the economy, but deflation presents policy makers and business people with some very tough problems that could turn a moderate recession into something much worse.
Recent columns in Business Week and Forbes have brought this issue out into the sunshine for the first time since 2002. One of those columns, written by a notable New York University economist whose gloomy predictions over the past five years now seem incredibly prescient, reports that within six months deflation will “become the main concern of policy authorities.”
Few remember the 2002 flirtation with deflation, and almost no one remembers the last time deflation was a real problem in the United States. That was between 1929 and 1933, when consumer prices fell by 26 percent. For most of our lives the main fear has been inflation, not deflation. In fact, it seems like only yesterday that inflation was picking up steam. Actually it was only yesterday in economic time. In July consumer inflation had accelerated to an annual rate of 5.6 percent. Since then, however, it has reversed course and that rate is now below 5 percent and dropping. The reversal in commodity prices has been more dramatic. One well-known index of commodity prices has fallen by 14 percent since June.
Serious deflation almost always results from collapsing demand, and that seems to be what we are experiencing right now. Household consumption expenditures dropped by 2.3 percent in the third quarter. This is only the fourth time since 1960 that the U.S. has experienced a quarterly decline in household consumption greater than 2 percent. The other three times were in 1974 (twice) and 1980, both of which were recession years.
This second quarter drop in household consumption, the falling rate of consumer inflation, and the incipient commodity deflation all were facts of the economic landscape before October’s financial market turmoil started wreaking havoc on household and business balance sheets. All indications are that U.S. consumers are continuing to reign in their spending. Thus, despite extensive infusions of capital by the U.S. treasury and the Fed, deflationary pressures might actually be building.
The two biggest problems with serious and prolonged price declines are debt deflation and prohibitively high real costs of borrowing. The first term refers to what happens when the value of debt-financed assets falls below the value owed to lenders. This has already happened to some people whose mortgage balances now are greater than the market value of their homes. Not only does debt deflation make bankruptcy seem like a rational alternative to borrowers, but it leaves lenders with those balance sheet losses we’ve heard so much about in the past few months.
The second problem – prohibitively high real costs of borrowing – arises when the Federal Reserve pushes short-term interest rates close to zero in an effort to stimulate spending in the face of collapsing demand. If prices continue to fall, then inflation-adjusted interest rates – the nominal rates minus the inflation rate, which in times of deflation is negative – can become very high. Such a scenario is famously cited as one of the contributing factors that exacerbated the situation in the early 1930s. In 1931, short-term interest rates were about 3 percent but prices were falling by 10 percent per year. This meant that real (or inflation-adjusted) short-term interest rates were 13 percent. It’s not hard to see why business investment would collapse with real borrowing costs so high. Put together falling household consumption and falling investment due to high real costs of borrowing, and add in falling exports due to a strengthening dollar, and you have something of a perfect storm.
Even though most of us have not spent a lot of time thinking about how deflation could destabilize our economy or how to combat it, there is one notable policy maker who has devoted a lot of thought to the topic: Ben Bernanke. If fact, back in 2002 Mr. Bernanke gave a speech before the National Economists Club in Washington, D.C., in which he laid out a comprehensive plan for dealing with deflation were it ever to occur.
Naturally he said it would be better for a central bank to make sure that deflation never got started, but sometimes things spin out of a central bank’s control. Collapsing housing prices and falling commodity prices are now economic facts. While these trends may simply be corrections from unsupportable run-ups in those prices prior to 2007, there is inertia to both inflation and deflation. Once they get under way, it’s hard to stop them.
Hence, we seem to be at a critical juncture. Demand is falling and the Federal Reserve is cutting short-term interest rates to stave off a deepening recession. But going into this recession, interest rates are already at historic lows, prompting some observers to fret that the Federal Reserve will soon run out of bullets to combat falling demand and prices. This observation refers to the fact that central banks cannot cut interest rates below zero. Once an interest rate approaches zero, if prices are falling the rate of deflation adds to the real cost of borrowing. In his speech, Mr. Bernanke addressed this concern, saying that “a central bank whose policy rate has been forced down to zero has most definitely not run out of ammunition.” He went on to list a number of unorthodox policy tools, some of which we’ve already seen Bernanke’s Federal Reserve engage in.
The message here is simple and straightforward. Deflation is a dangerous problem that can turn a bad recession into something much worse and longer lasting. In part, this is what happened in the 1930s. While there’s no consensus yet that we are on the road to a deflationary spiral, we do seem to be at a critical tipping point. To take a “glass half full” perspective, if deflation is at least a possibility it’s good to know that the current Federal Reserve chairman is someone who has already thought deeply about the issue and about ways of dealing with it. That’s something we didn’t have in 1930.
¶2, line 1, “Business Week”: James C. Cooper, “A Real Risk of Deflation,” Business Week, October 30, 2008. http://www.businessweek.com/magazine/content/08_45/b4107008158343.htm
¶2, line 1, “Forbes”: Nouriel Roubini, “Get Ready For ‘Stag-Deflation,” Forbes, October 30, 2008. http://www.forbes.com/home/2008/10/29/stagnation-recession-deflation-oped-cx_nr_1030roubini.html
¶8, line 4, “Speech”: Ben Bernanke, “Deflation: Making Sure ‘It’ Doesn’t Happen Here.” Remarks before the National Economists Club, Washington, D.C., November 21, 2002. http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm
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