In the past week or so, the Producer Price Index (PPI), a measure of the cost of making things, was reported to have fallen by a whopping 1.9% in a single month. A few days later, our fearless Fed chairman stated that deflation (a general decline in prices across the economy) was more likely than inflation at present. These two news items combined to rekindle fears of deflation. And, to think, I am old enough to remember when inflation was regarded as far and away our worst enemy.
With all of this talk, I thought a little perspective might be in order. You may initially wonder, “What’s so bad about falling prices?” After all, we have been raised to dread rising prices since World War II, and upward movements have been the grand obsession of the Greenspan era. If you take a bit larger view of things, however, you quickly discover that (1) there has been much more deflation than inflation across the annals of history and (2) it is with certainty the greater problem.
Deflation is essentially bad because it can grind business and consumer activity to a halt. If we fret over inflation, we tend to “buy now” and potentially overheat the economy. While not particularly pleasant, that is an outcome we can deal with. If we expect deflation, on the other hand, we tend to “buy later,” or perhaps “buy never.” If you think something will be less expensive in six months, it is often rational to postpone the purchase. In another six months, the same situation applies. Thus, we tend to curtail our spending dramatically.
In a similar vein, inflation allows us to repay past debts with “cheaper” dollars. The opposite occurs with deflation, thus making it more difficult for companies and households alike to deal with existing loans and creating a disincentive for future acquisitions through financing.
I could go on and on, but the simple fact is that deflation is bad. Period. Having said that, I must quickly add that I see very little possibility of a downward spiral in prices. Such reductions are only ultimately harmful if they reflect a structural drop in aggregate demand—an economist’s weird way of saying that, as a global village, we all decide to permanently spend less. I don’t see that happening.
The recent price declines are largely the result of the direct and indirect consequences of petroleum prices returning to “normal” following the lead up to the War in Iraq. Prices in prior months were higher than they otherwise would have been as a speculative bubble developed in response to perceived risks to the oil supply chain. As the perceived risk diminished, so did the prices. This pattern is part of the typical ebb and flow of the economy and poses no cause for particular concern.
There is also an ongoing decrease in prices for some goods due to gains in productivity and efficiency. Computers, cellular phones, DVD players, and many other things cost less than they once did. Again, that is a good thing. It permits higher wages and purchasing power without fueling inflation.
The actual demand-driven part of recent pricing patterns can be almost exclusively attributed to reluctance on the part of businesses to invest in the face of the uncertainties associated with September 11, corporate accounting scandals, and the threat of war. This triple whammy is unfortunate, but it is also temporary and not structural. Consumers have continued to purchase cars, houses, and other durable goods, and US companies will quickly begin to spend as the uncertainty diminishes (orders are already on the rise in several key sectors) in a very attractive interest rate environment. In short, there is no indication of any permanent shutdown of entrepreneurship and ingenuity.
Deflation. Is it a problem? You bet it is! A really big one! Is it likely to happen? Nope!!