RateWatch #356 – Record Low Rates. Deflation.
May 17, 2003 by Dick Lepre

The D-Monster: Evil Twin of the I-Monster

Long-term readers or the RateWatch Newsletter are familiar with our old friend, the I-Monster (inflation).

We have, lately, been hearing about his evil twin, the D-Monster. The D-Monster is Deflation.

The fact is that Japan has been hurt by deflation for about 10 years, raising the question: can it happen here?

It is time to take a look at what deflation is, if there is any chance of it happening here soon,
and what the consequences might be.

First: Disinflation

Disinflation is a decrease in the rate of inflation. The rate of inflation decreases but its actual value
is still positive. If we uses CPI to measure inflation, then we have been in a disinflationary environment since the early 80's.

The attention to disinflation is directed to the fact that as the increase in CPI continues to fall it
might hit and pass through zero and we would then have deflation.

Creedence was added when Greenspan suggested that deflation is a potential threat. (Note: he also brought this up in Octobet 1998.) The risk, at present, is "too much stuff." When there is too much stuff, the price of stuff falls.

The Asian Currency Crisis resulted, in part, from an unwise and too large infusion of capital into
plants to make more stuff. There was plenty of fault to spread around. Companies, Asian governments, banks and investors all had a hand. When Asia was unable to consume these goods, there was excess capacity. That glut may have been exported to the U.S. resulting in disinflation and, if the problem is not confinable, deflation.

Our focus for so long has been on preventing inflation that, even though outright deflation is a somewhat far-fetched scenario it is good that we are becoming aware of it.

What Happens in Deflation?

Just how close to deflation is the U.S. economy? Inflation (which hit a post-World War II high of 13 percent in 1979) is running at a 34-year low of around 2.5 percent. So, it wouldn't take much to transform disinflation - progressively smaller price increases - into declining prices.

Deflation might be a nightmare because we are not prepared for it. Deflation is the opposite of
inflation. Prices of goods and services would fall over time. Cash would increase in value. Debt, which was no big thing in times of inflation, might prove fatal to municipalities, companies and individuals. The effective interest rate would rise and defaults might result. This could lead to chaos in banking. Debt heavy companies would feel pressure to cut wages and salaries. Folks with
mortgages might not have any income as their jobs disappeared. In deflation, debt is a curse. A retiree on a fixed income would find himself richer each month. One might curse the mortgage
broker who got them a 6% fixed rate mortgage. Aarrgh!! My payments are fixed. I have fewer
dollars of income. Each month the value of that fixed number of dollars would increase. The value
of my home would decrease. Why should I make my mortgage payment? In the first four years of the Great Depression, prices fell an average of 8% per year and big chunks of the economy went down with them. 

In deflation there is little incentive to invest in plants and equipment.  Why invest today if the expense of doing so will be less next year?

An example of deflation killing an industry is Telecom.  Large capital investments in bandwidth
were made – some of it with borrowed funds – and the price of bandwidth collapsed.  The telecom industry was hurt by its own competitiveness, a side effect of a free-market economy.  Karl Marx snickered in his grave.

Inflation and deflation can be viewed in a historical perspective. In the book "The Death
of Inflation," British economist Roger Bootle points out that inflation has been the exception throughout history, not the rule. British studies show that in 1932, prices were slightly lower than they were in 1795. And, according to Bootle, when one looks at prices dating back to the year 1264, 97 percent of all the price inflation in the last 700 years has occurred since 1940. (I am not sure what this implies but it sounds "cool".)

But really. It seems far-fetched that any nightmare deflation scenario could occur soon.

What I see as more likely is the following:

1) inflation is (for the time) under control.

2) Americans, unlike Japanese, are spenders. We are not going to stop spending.  That is down-right un-American.  The Japanese are savers. They actually think about the future.  Look where it has gotten them.

3) The global economy has served to temper U.S. inflation.  There is not a world-wide environment of deflation which would necessitate lowering prices and wages here.  Tempering - yes; lowering - I think not.

4) We now know that we can have very low  unemployment (it was as low as 4.5%) and yet very low inflation.  The root of inflation is not what it was once thought to be.

5) Computer prices continue to drop and are now available to most anyone. The Internet promotes price competition. The cost of transactions, such as processing an online application, are decreasing. People are trading stocks at rock-bottom fees using the WWW. Again, this is a price-tempering force, not a source of deflation.

6) the fact that the Chairman of the Federal Reserve would even mention deflation indicates that we are aware, at an early enough stage, that it is a serious threat. This alone might keep deflation from becoming a problem.

7) Deflation - the dangerous Japan-like deflation - would occur only (to repeat paragraph II)
as a parallel to a lengthy period of recession. Could that happen?  Yes.  Is it likely? No.

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