November 18, 2008
One month a trend does not make, but today's update on wholesale prices invites the obvious speculation about what may be coming.
As for assessing the here and now, it's clear that the deflationary winds are blowing. Producer prices posted a jaw-dropping 2.8% tumble last month, the Labor Department reports. That's the deepest monthly decline for this series since the Great Depression, although that's just an educated guess since the Labor Department's PPI archive on its web site only has numbers going back to 1947. Since then, last month's drop is by far the biggest.
Monthly declines in the PPI series are hardly unprecedented, even if the magnitude of last month's drop is in a class of its own. But that's not the issue; rather, the economic context of the moment, coupled with a massive price decline in wholesale prices, suggests that an extended bout of deflation may be at hand. Tomorrow brings the October update for consumer prices, and the news is expected to be better, i.e., prices are expected to rise. We'll see.
Why all the anxiety about the potential onset of deflation? To be blunt, avoiding the Big D is always a priority for policymakers. Typically, the inflationary bias does the heavy lifting on that front, leaving governments to worry about other things. But sometimes the pricing landscape turns upside down. Is such a moment at hand? As always, the future's unclear, but it may be time to err on the side of caution about deflation's threat.
Although the prospect of falling prices has obvious appeal for consumers, economically speaking it's a virus that, if allowed to fester, creates any number of problems. The reason is that if deflation takes root, the normal incentive to buy and borrow takes a holiday, which elevates the odds for economic contraction. The fact that the U.S. is already in recession only makes the additional threat of deflation all the more troubling.
If prices are falling and everyone expects more of the same, the temptation increases for delaying purchases to cash in on future discounts. But the sentiment motivates more of the deflationary momentum, which inspires more deferred consumption. At some point, the trend turns into a deflationary spiral that feeds on itself, and at that point there's not much anyone can do to pull the economy out of a dire tailspin.
Borrowing and lending in a deflationary environment also suffer since debt servicing becomes increasingly burdensome. The normal inflationary scenario is borrowing in today's dollars and repaying tomorrow in less-valuable dollars. Under those conditions, there's a natural appeal for assuming loans. The opposite is true with deflation: the expectation of repayment with dearer dollars creates a disincentive for assuming debt. All the more so since purchases implies buying assets that are likely to decline in value, which is no one's idea of a savvy business plan. For obvious reasons, this scenario is a disaster for stimulating economic growth.
History is quite clear on those rare occasions when deflation strikes. The two great 20th century examples of deflationary environments—the Great Depression in the 1930s and Japan's experience for much of the past 18 years—need no explanation for why price declines of any duration must be avoided.
The good news for the moment is that there's still hope. In today's news on producer prices, the primary source of the price decline in October came from collapsing commodities, energy in particular. Core PPI, which strips out food and energy, actually rose last month by a rather robust 0.4%, matching September's gain. Deflation, in other words, hasn't affected all prices. Therein lies the basis for hope that deflation generally can still be avoided.
Nonetheless, today's PPI report sends a strong signal that the risk of deflation has jumped substantially. It's not yet fate, but it could be if policymakers don't act forcefully and in a timely manner. The risk is real, in contrast to the Fed's ill-advised deflation fears in 2001-2003. This time it's the real thing, and the clock may be ticking. Indeed, the recession has only just begun, and so it's not yet clear how deep and enduring demand destruction overall will be.
Tomorrow's consumer price update will offer further guidance on the state of the pricing environment. But given the general economic backdrop of fading demand, which feeds deflation's fires, today's wholesale price report must be taken a warning sign that the D threat is a real and present danger. If and when deflation has the economy by the throat, the virus becomes far more difficult, if not impossible to contain.
Indeed, the usual monetary levers no longer work in deflation because interest rates can't be negative even though prices can be. And so the limit imposed by what's known as the zero bound in monetary policy may be near. The Fed funds rate is already at 1%, meaning that the opportunities for lowering interest rates are constrained. To be sure, the Fed has alternative means of stimulating demand, although it's unclear how effective such efforts will be, in part because they're so infrequently used. Deflation, in short, is the exception and so there are few real world examples of fighting the beast.
Once again, let's remind that it's not yet clear that deflation is destiny for the U.S. economy, even if the risk has jumped sharply. Much depends on how fiscal and monetary policies unfold in the coming weeks and months. Ditto for the economy. It's possible that the deflationary risk will pass of its own accord, but for the moment that's a risk the country can't afford to take. Better to err on the side of too much stimulus rather than too little.
Yes, there's a risk that the excess stimulus won't be pulled back in once the deflation danger has passed. That too is a potential problem that can't be dismissed. But that's a battle for another day. Now is the time to prepare for an all-out war on preventing deflation.
Posted by jp at November 18, 2008 10:27 AM
I think some people here wish to have your cake and eat it too.
What is wrong with prices coming down to where they should be, and how the heck is the savings rate going to go up if you keep pushing people to keep borrowing and spending more??? The math is off here.
Yes, it will take some time spent in pain, but so does cancer treatment. The cancer of binge borrowing and spending is now in stage 3 threatening to kill the spender-patient.
As for Japan, the problems have been structural and cultural - ongoing deflation is the symptom not the cause of their troubles.
Or ... think of it this way ... if your kid is addicted to drugs, will you push them to take more because they'll feel good or will you send them to rehab?
So, yes, be careful what you wish for.
Posted by: ag at November 20, 2008 1:30 AM
I was struck by the comment that governments have no remedy for deflation. How about a major war? Many economists think WWII stopped the great depression. Large numbers of young people drafted and killed, taking them off the labor market, and lots of government spending to drive up demand for the employees remaining at home. Let's not forget the fear that the war will be lost, making it less attractive to wait for tomorrow's lower prices. Problem solved!
Posted by: D.Cohen at November 19, 2008 1:04 PM
From a consumer perspective, falling prices are wonderful. But we need to make a distinction between falling prices in a narrow corner of the economy due to productivity and technology vs. a general price deflation due to economic weakness. The risk of the latter is the subject of the moment. Japan's deflationary problems have been widely documented by economists the world over, and the conclusion is that a fair amount of the country's troubles are related to a general deflation, although that's merely a symptom of deeper ills. Be careful what you wish for.
Posted by: JP at November 19, 2008 10:24 AM
this statement is totally ridiculous...
...Japan's experience for much of the past 18 years—need no explanation for why price declines of any duration must be avoided.
declining prices is not deflation. Has the declining price of computers for the last 20 years stopped purchases of computers? Has it resulted in declining economic activity?
Central banks should just let prices be dictacted by supply and demand. Trying to push prices in a direction not supported by fundamentals ultimately results in a painful correction back to the true value.
Posted by: jzw at November 18, 2008 9:27 PM
I accept the premise that deflation generally leads to a decline--maybe at an increasing rate--in economic activity.
How, as a nation, are we to come to grips with the massively excessive personal, business, and government debt we have accumulated as well as the negative savings rate if we do not spend less (which tends to cause deflation)???
We have really dug ourselves a massive economic hole at all levels. It seems that it will take a lot of economic pain to get out of it.
Posted by: Terry at November 18, 2008 10:42 AM