Deflation: Worst-Case Scenario or Already Here?

In following up on last week’s post (”Inflation or Stimulus: An In-depth Look At the Fed’s Response to the Credit Crisis“) on the possibility of inflation, I want to focus today’s post on the opposite phenomenon: deflation.

As evidenced by the huge expansion of government borrowing and Fed Quantitative easing, it is deflation which is currently the paramount concern of policymakers. While falling prices would seem to represent an ideal solution to the current economic downturn, deflation is actually quite pernicious if left unchecked. To elaborate: “When prices fall across the board, businesses and consumers postpone purchases because they expect lower prices later, or worry their incomes will decline or don’t want to acquire assets that will fall in value. Shrinking demand forces sellers to cut prices further, triggering a vicious cycle.” Deflation is also detrimental to consumers with liabilities, which remain the same even as incomes are falling.

Now that we understand what deflation looks like, let’s examine its likelihood. In fact, the current economic environment represents a perfect breeding ground for deflation. For example, both consumers and businesses are using stimulus and bailout checks to pay down debt, rather to increase spending. In addition, businesses are selling out of inventory rather than ramping up production, due to uncertainty for the future. Bond yields are rising, making it more expensive - and hence less likely - for companies to borrow and invest.

And what about the data? The Retail Price Index, “RPI - which turned negative for the first time in almost 50 years in March - is expected to fall from minus 0.4% to minus 1% in April.” The Consumer Price Index, meanwhile, “declined by 0.7 percent year-over-year in April, the largest 12-month drop since 1955.” It’s hard to take this data seriously, however, given the “seasonal adjustments” and “stripping of so-called volatile energy prices, and using the dubious ” ‘owners equivalent rent,’ OER, to measure consumer housing expenses” in order to conceal the actual decline in property values. In short, the actual decline is probably much worse, especiall given the steep drop in commodities from 2008.

At least Fed Chairman Ben Bernanke is satisfied, and was most recently quoted for his belief that “the risks of deflation were receding.” Bernanke remains committed to pumping money into the economy via its purchases of government bonds. It still has a ways to go in making good on its promise to buy more than $1 Trillion in securities.

While it’s easy to blame the Fed, it’s also hard not to begrudge it some sympathy for having to toe a very thin line between deflation and hyperinflation. In the event that its successful in forestalling a decline in prices, it will have just enough time to catch its breath before drawing all of the new money out of the economy so as to prevent inflation from taking hold and another bubble from forming in asset prices.