Deflation is one of those semi-mysterious economic events that is often talked about but rarely seen. In simple terms, it is a general and persistent decline in prices. For the consumer that might seem a boon. As prices decline a dollar buys more goods. Those folks who have jobs or cash see the value of their holding increase, the longer they wait the greater the potential gain.
But while deflation might grant a short term individual gain it can be hugely damaging to the overall economy. When falling prices become widespread and sustained they generate a self-reinforcing cycle of economic contraction: faltering consumption leads to reduced production; as demand for their products shrinks businesses reduce payrolls; unemployed workers cannot spend which again reduces consumption, production and then employment. A deflationary cycle is one way recessions turn into depressions.
Deflation is often a monetary phenomenon caused by a drop in the supply of money or a drop in credit. During the Depression the failure of almost a third of U.S. banks severely curtailed the supply of money in the economy. Not only was the multiplier effect of bank deposits backing a supply of credit many times larger than the deposit base lost, but in many cases the original deposits vanished as well. With vastly fewer dollars circulating in the economy prices tumbled. People bartered for goods instead of buying and in some places local governments tried to create their own currencies to replace scarce dollars.
Something akin to that monetary contraction is happening now as banks restrict credit to financial institutions and consumers. The cars and houses that might have been bought with borrowed money sit unsold.
Deflation can also have a supply and demand origin. A long-term increase in the supply of a particular good or in its manufacturing cost brought about by productivity improvements can reduce the price charged for those goods. Competition from foreign, lower cost manufacturers might do the same. This might be called beneficial deflation, in that consumers often respond to these types of limited prices decreases by spending more on other items. The general level of consumption does not fall and everyone has more goods and feels wealthier. An example of this selective goods deflation is the effect of manufactured goods from China over the past generation. For many items prices have hardly risen in a decade or more. There are more and better quality goods available and though paychecks for many have stagnated, consumption has not. When presented with a cheaper good consumers do not save the difference.
Supply generated deflation also tends to be limited in scope, not all goods in an economy are affected. And though it tends to tamp down overall inflation it does not produce a generalized decline in prices.
Demand can also falter when consumers have reason to fear for future jobs and income and so postpone or eliminate consumption. This reduction can become generalized if the prospective slowdown is severe enough.
The more widespread and prolonged the price declines the more dangerous for the economy. When price declines affect a majority of goods and services, consumers begin to anticipate a lower future price and postpone purchases. Just as inflation promotes current consumption in place of future consumption because goods are bought today in anticipation of higher prices tomorrow, so deflation substitutes future consumption, when prices are expected to be lower, for current spending.
A clear example is the current residential housing market. In many places home prices are now at the lowest levels in years. If these prices had been offered a year or two ago they would have brought out a slew of buyers. But now the same house at the same price attracts no offers. Why? It is not only that mortgages are harder to obtain and that people are reluctant to make a large purchase in a recession. The U.S. economy has, until very recently, had half a decade of very good growth. Not everyone has lost their jobs or a fortune in stocks. Not all bonuses have been spent. Nor has the desire to own a home completely dissipated. Home buyers are holding back because they are waiting for prices to go lower. Home price deflation has become the norm, it is the market expectation. And it is these recalcitrant buyers who are helping to drive prices even lower.
But housing is just one market. The same circle of anticipation of lower future prices forestalling present consumption can become general in economy. It is endemic deflation that is so feared by economists. Contracting consumer spending is not just an individual consumer decision. American GDP is 70% consumer spending. If consumers add anticipation of lower future prices to layoffs, lost wealth in stocks and home equity, the potential drag on economic growth becomes very large. Falling consumption means fewer goods produced and a shrinking manufacturing sector which in turn generates cutbacks in production and employment as producers match output to sales. Laid-off workers buy even less, prompting more production cutbacks further layoffs and a spiral of declining production, employment and consumption.
In order to avoid the contracting economic spiral generated by deflation governments and central banks have one policy—re-inflation—or print and spend money. The Federal Reserve and Treasury have created trillions of dollars in the past year in their attempts at rescuing the banking system. Trillions more may yet come. President elect Obama has talked of a stimulus package of more than $500 million. The Fed Funds target rate is 1%; it could well go to 0.5% or lower at this week’s meeting. The effective rate has been less than half the target rate for months.
Inflation, deficit spending, very low interest rates, these are the tools the U.S. government is using to fight incipient deflation. Is it any wonder the dollar has lost heavily in the past several weeks?
Joseph Trevisani
FX Solutions LLC
Chief Market Analyst
Joe@fxsol.com
