Steve Verdon believes this to be good news for the economy. Quite the contrary, deflation is very bad news unless it’s mild and temporary. When the average price level goes down, employers are forced to cut wages or lay off workers. Debtors have a harder time paying off their loans when dollars are more expensive, and are more likely to walk away from their debts when the price of the collateral falls below the balance of the loan. Banks are also more likely to fail, as default increase and money to pay back depositors is harder to come by.
The deflationary death spiral of price deflation, declining marginal wages, and bank failures (which in turn contribute to deflation by reducing the money supply and velocity of circulation) is a defining feature of depressions as opposed to mere recessions. A big part of why we haven’t had a depression since the 30s is that the Fed has learned from their mistakes of 1929-1933 and scrupulously dumped big piles on newly printed money into the economy every time deflation seemed likely.
This is not to say that we’re headed into a depression. A 1% decline in prices in a month is only a problem if it continues; if price levels stablize in a month or two, we’re fine, and Dave Schuler notes in the comments of Verdon’s post that the futures market expect inflation rather than deflation next spring. And “Helicopter” Ben Bernanke has been scrupulously dumping the requisite big piles of newly printed money into the economy — M0 is up 7% in September and 25% in October (source).
My interpretation of this data is that the Fed hasn’t been dumping quite enough money into the economy, but they’re trying and is likely to get it right over the next few months. Conquences will be dire, however, if they get it badly wrong in the same direction several periods in a row.
Update: Also via Steve Verdon, the Fed is signaling that it intends to cut interest rates. This is consistant both with my interpretation (that the Fed underestimated deflationary pressure and will adjust to avoid it) and Steve’s (that the lack of inflation frees the Fed’s hand to cut rates to stimulate the economy).
{ 12 comments }
I believe this drop in the CPI is due primarily to the drop in oil prices, and if that is the case, then the CPI should behave more normally starting from this month or next.
If it is just oil prices returning to more rational levels, then I don’t see it causing underlying problems for the economy.
The Rich Wasp’s last blog post..A Question For My Hoosier Readers
Good point. If it’s just oil, it’s noise. That’s why policy decisions are usually made based on core inflation (excluding food and energy) rather than overall inflation, as food and energy prices are volitile enough that in the short term including them in the data adds more noise than signal.
The Rich Wasp has it right. This is not a sign of deflation, just a sign that oil prices are in a chaotic state of price fluctuation.
However, I don’t think the current price is “rational”, I think something around $90 a barrel is reasonable and sustainable, and will provide adequate incentives to develop alternate fuel sources. To me the current fluctuation in oil is much like the fluctuation in the stock market. It’s currently irrational.
CosmicConservative’s last blog post..Hottest 60s sitcom babe?
I went and looked up the raw data, which I should have done before hitting post.
Yes, it’s mostly oil. Energy prices are down 8.4% from September. Food is up 0.3%. Core CPI (everything but food and energy) is down 0.1%, which is not a worrysome amount.
If you go to the original news release, you see that excluding food and energy, the CPI declined by -0.1 in October instead of -1.0. Most of this drop was because of energy costs.
I’m not worried about dangerous deflation at the moment.
Mikeca’s right, an energy-driven CPI drop is unreservedly good news.
The question of whether core deflation is good or bad also depends on who are.  Deflation is good from a consumer’s point of view, assuming all else stays constant: the same money buys more goods.
It also may not be bad news for the company selling at a lower price. Companies are constantly striving to lower costs – and in fact it is always getting cheaper to make things. Deflation may be the result of price  competition between increasingly efficient competitors.
OTOH, core deflation is bad for a certain class of people — those who owe debt at a fixed interest rate, which is typically mortgageholders. Just as inflation is good news for debtors — you can pay off today’s loan with tomorrow’s less valuable dollars — the reverse is true for deflation.
Yes, Mikeca’s right. I made the same point in the previous comment (probably posted while he was typing his).
As for whether core deflation is good or bad, the key thing you said was "assuming all else stays constant". It doesn’t. Core deflation also drives down nominal wages, which generally leads to unemployment because wages are sticky downwards. It also tends to have a negative effect on the financial system by driving down nominal interest rates (encouraging people to hoard cash instead of investing) while increasing the default rate on bank loans.
 the key thing you said was "assuming all else stays constant". It doesn’t.
That depends on a given consumer’s situation.
Core deflation also drives down nominal wages
Not necessarily. Productivity improvements may allow for higher wages and lower prices.
It also tends to have a negative effect on the financial system by driving down nominal interest rates (encouraging people to hoard cash instead of investing)
Again, this is a double-edged sword.  Lower interest rates also make it much easier for companies to borrow. It means projects with lower ROI are more acceptable.
The fact we have deflation tells me there are still huge amounts of money chasing a good return.
Productivity improvements may allow for higher wages and lower prices.
Yes, but only if deflation is less than productivity growth. That’s plausable for the 0.1% month-over-month (1.2% annualized)Â core deflation we’re actually seeing, but not for the 1% month-over-month (12.6% annualized) deflation I thought we were seeing when I made the post.
Again, this is a double-edged sword.  Lower interest rates also make it much easier for companies to borrow. It means projects with lower ROI are more acceptable.
Lower real interest rates would have these effects. Lower nominal interest rates due to deflation would not, because declining nominal revenue due to declining nominal prices would precisely cancel out the lower nominal interest rates.
You also have the problem that the supply of credit dries up as nominal interest rates decline to zero. If you can get a 0% nominal return by holding cash, why take the risk of investing your money to somebody who’ll pay a 0.2% nominal interest rate? And that may well be the most someone is willing to pay if there’s significant deflation, as that might be a real interst rate of 5-10%.
I’ll grant that slight deflation is mostly harmless, so long as nominal interest rates and nominal wage growth remain positive, and so long as the transition from inflation to deflation isn’t so sudden as to create an expectations shock (this last is a problem with any sudden change in inflation/deflation levels, regardless of whether inflation crosses the X axis). But severe deflation is inherently problematic, moreso than the equivilent degree of inflation (i.e. 10% annual deflation is more harmful than 10% annual inflation).
 Lower nominal interest rates due to deflation would not, because declining nominal revenue due to declining nominal prices would precisely cancel out the lower nominal interest rates.
Again, that depends on a particular company’s situation. All else being equal, lower borrowing costs are good. Whether a particular company can still find good ROI is up to them.
You also have the problem that the supply of credit dries up as nominal interest rates decline to zero.
No, precisely the opposite: low interest rates are a function of too much money chasing too few good investments. Japan never had a credit squeeze problem when they experienced deflation.
Again, low real interest rates are a function of too much money chasing too few good investments. Low nominal interest rates during a time of deflation just means that you only need to charge a 1% nominal interest rate to get a 6% real return on investment because a year from now your dollars will buy 5% more. In order to pay that loan back profitably, you still need a project whose real ROI is better than 6%.
Japan didn’t experience a credit crunch because their deflation rates were less than 1% a year, in the mostly harmless range. Nominal interest rates did go to almost zero, but only because real interest rates were absurdly low. To get a credit crunch from deflation, you need a much higher deflation rate. Something along the lines of the 8-10% annual deflation the US experienced in 1929-1933.
The Depression’s deflation was driven by a massive flood of bank runs (because of the 10:1 margin loans)that greatly reduced money supply (this became so severe private ownership of gold (which banks needed to hold in order to lend) was outlawed, and this eventually led to fiat currency which has essentially infinite potential liquidity).   The deflation was more a symptom than a problem.Â
While general price stability is obviously desirable, whether a low level of inflation or deflation is more desirable tends to depend on whether one is a net creditor or a net lender. If you have money, you’d like it to be more valuable going forward, if you owe money you’d like it to be less valuable going forward.
Comments on this entry are closed.