Thursday, November 20, 2008

The deflation threat is small

Bloomberg published article today that suggests deflation is a real threat to the U.S. economy. In my opinion, deflation is not going to be a real threat until falling prices become embedded into expectations. However, there is a growing risk that the current credit crisis contracts the money supply enough to drive prices downward over a period of many consecutive months, resulting in negative inflation expectations. But that outcome has a low probability. From Bloomberg:
``The Federal Reserve put deflation back on the table as a significant policy concern,'' said Vincent Reinhart, former director of the Fed's Division of Monetary Affairs, who is now a visiting scholar at the American Enterprise Institute in Washington. ``There does not appear to be any barrier to lowering'' main rate below the current 1 percent level, he said.

Deflation, or prolonged declines in prices, hurt the economy by making debts harder to pay off and lenders more reluctant to extend credit. Japan is the only major economy to have suffered the phenomenon in modern times. `Lesson' for Kohn

``A lesson I take from the Japanese experience is not to let that get ahead of us, to be aggressive,'' Bernanke's deputy, Vice Chairman Donald Kohn, said in answering questions after a speech yesterday in Washington. ``Whatever I thought that risk was four or five months ago, I think it is bigger now even if it is still small.''
Is deflation a real threat?

I love how Bloomberg turns a completely innocuous statement by Donald Kohn into a suggestion that deflation is a serious concern. The risk of deflation is higher than it was four or five months ago? Ahem, four of five months ago was roughly June or July when annual inflation hit 4.9% and 5.5%, respectively. The price of oil was surging, and gas and food prices were rising precipitously. Of course there’s a bigger risk today – that’s called a recession!

Expectations play an important role here

Back in July – when the price of gas exceeded $4/gallon – the Fed hawkishly followed measures of inflation expectations because once those puppies get imbedded into consumer and firm behavior, then you have a problem. If banks expect prices to rise over the next year, then current interest rates increase. If firms expect prices to rise, then current wages tick up. Rising inflation expectations could create a mess that results in surging inflation.

But just as the Fed was worried about price expectations rising, the Fed will watch closely price expectations falling in this recession-backed credit crisis. If banks expect prices to fall over the next year, then current interest rates fall. If consumers expect prices to fall, then current spending could decline. Falling inflation expectations could create a mess that pushes inflation down, making debts harder to pay back (because current loan terms are usually made at a fixed rate, rather than an adjusting rate) and curtails consumer spending.

Inflation expectations are still elevated

Right now, the average consumer still believes that prices will rise over the next year, and by some measures, by 6.9%. So as long as inflation expectations remain elevated, “deflation” is unlikely to drag the economy down, because current firm and consumer behavior will not change.The chart illustrates annual inflation and inflation expectations spanning the years 1978 to 2008. Annual inflation is old news, but monthly shifts drive the annual numbers, so the trend is a fair assessment of current conditions. The current inflation rate, 3.7%, is still elevated above the average over the years 2000-2008, 2.9%. Furthermore, the US economy is in a recession, and inflation falls during recessions.

Until falling prices become embedded into expectations, I see consumers as slightly better off when labor income is declinine and the U.S. economy is in a recession. The disinflation acts more like a stimulus than a real threat.

The better question is: will current credit conditions cause a contraction in the money supply enough to drive down inflation expectations?

The Fed reports that M1 and M2 rose in October. However, in the week ending November 3, the non-M1 components of M2 (Table 2) contracted. Although the 4-wk moving average still exhibits growth in M2, the deflation scenario presumes that credit market disruptions cause the money supply to contract going forward. Obviously there is a risk here.

The Fed will keep the printing presses on, and eventually, this will “buy” rising prices; at least that’s the theory. To be sure, the Fed’s actions alone are unlikely to get us out of this mess. But at this point, it can’t hurt to keep the presses on, and hope that it is at least partially enough.

By my simple calculations, it would take a record-breaking eight consecutive months of a 1% decline in prices (October's decline, or the biggest since 1947) to drop the annual inflation rate below zero. And if it stayed there, expectations could change, causing disruptions in the macro-economy.

However, it would take a massive downturn in core prices to make that happen because energy – which was most of the story for October’s decline – is unlikely to fall to zero. So Congress has until June, at the very least, to get their act together, pass a stimulus bill, and spend.


For now, declining monthly prices are in some sense a good thing. The oncoming recession is expected to be quite severe, and with labor income remaining depressed, at least consumers will pay less for gas, energy, and other necessities. To be sure, the state of the credit system could cause serious disruptions in normal activity, but that is far from a sure thing, and as long as Congress gets on board and the Fed keeps the printing presses on, the deflation risk is close to zero.

But at this stage in the game, the only sure thing is the speed of light.

Rebecca Wilder


  1. It was interesting that last night, ABC News reported that consumers were likely to wait until after the Christmas season to purchase because they feel the prices will be lower. With Black Friday going pre-Thanksgiving, the outlook for Christmas sales doesn't look good. What's to say that 3 months out, things will have changed enough (to the negative) to warrant further contraction of spending. Throw in the do-nothing-until-Obama-is-in crowd and we have a fine time coming. Granted, this is not macroecon but each of us is one of the mass=comsumers.

  2. I posted a couple of thoughts on deflation on my site today. I've been in your camp for awhile, but I'm know seriously starting to consider the threat of deflation. As the market continues to break it's prior lows, this will continue to have the effect of reducing consumers willingness to spend.

    The "wealth effect", declining asset prices, is having a significant effect. Most people are afraid to look at their 401k statements, because they hope that we'll bottom soon and things will be OK.

    My fear is that we don't bottom right away and move towards Japan like deflation scenario. I did some analysis on the Japanese equity market. In 90's the drop was 80%. If we experience a similar drop, that puts us back at 1987 highs.....2800 or so. Unfathomable to think we could drop that far.

    Could it be the "black swan".......Don't know.

    Time will tell....we'll have to watch and wait

  3. are house prices deflating?

    are share prices deflating?

    are commodity prices deflating?

    could wages fall with high unemployment?

    are auto prices deflating?

    as long as the fed...

    as long as congress...

    if it walks like...


  4. Thank you all for your comments.

    As you all suggest, I may be in some sort of fairytale land. Admittedly, we are starting off at a much lower rate of inflation (let's say than in the 1980s), so it would be very easy to get to a deflationary scenario.

    To be sure, I am not suggesting that the threat does not loom. Simply that the probability of a deflationary disruption in the macro-economy is small.

    The risks are certainly there. Let's see what the Fed and Congress can come up with.

    Thanks for reading, Rebecca

  5. Rebecca writes:
    [But at this stage in the game, the only sure thing is the speed of light.]

    Now we're getting into my end of expertise...and I have news for you.

    The speed of energy is not constant, and it's speed to begin with must be stated relative to a reference in space.

    Makes Economics suddenly look a bit less like a moving target.


  6. Hi Stephen,

    I got nothing. Any suggestions as to a better constant?


  7. I'm starting to think the deflation threat is real. The source of that threat comes from wages. I think economists are underestimating how quickly the service sector may produce unemployment. Simply put, much of the sector is oriented towards discretionary spend, and it may prove much more cyclical than in previous recessions.

    So what happens to unemployed service sector employees? They have little in savings to tide them over. They also have little in the way of fungible job skills that can smooth the transition to other industries. They are likely to offer to work for less pay in order to secure employment.

    There's lots of room for surprise here. Declining service sector wages may be one of those.

    IMO, the question is what the Fed will do about deflation, not whether the threat exists.

  8. "the deflation scenario presumes that credit market disruptions cause the money supply to contract going forward"

    No money supply figure standing alone is adequate as a "guide post" for monetary policy. However:

    In a country whose population and productivity are growing, it is proper that the FED should allow bank credit (defined as total loans and investments at all commercial banks), to expand (rate-of-change), but not excessively.

    Bank Credit peaked in March 08 (13%annual rate-of-change) and then declined until Sept (5% annual rate-of-change). It then surged in Oct reaching (11% annual rate-of-change).

    Bank Credit is currently following a deflationary path. Bank Credit (loans-deposits), has has been in decline since 10/22/08.

    The monetary significance of the growth in bank credit derives from the fact that commercial banks create new money (initially transaction deposits) on a dollar-to-dollar basis when they make loans to, or buy securities from, the non-bank public.

    Bank credit proxy” (total daily average of member commercial bank deposits) used to be an FOMC target from 1966 until 1969:


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