Tuesday, August 03, 2010

Deflation Fears Growing

Right now, consumer prices are barely rising at a rate of one percent, causing some economists and central bankers to fear that they might actually start falling. That's called deflation.

Deflation is a particularly worrisome outcome because it de-incentivizes investment. All investments simply lose value over time, even on an annual basis. Buying houses, cars, commercial buildings, factories and the like suddenly seem like bad ideas and bad investments.

But without these investments, the economy will spiral downward in horrifying fashion. The last time the US experienced deflation was during the Great Depression.

As St. Louis Federal Reserve Bank President James Bullard recently noted, once deflation starts it is extremely difficult to stop.

Central bankers tend to think that they can stop inflation more easily than deflation, and so the Fed has rolled out all of its weapons in the fight to prevent deflation: increasing the money supply and keeping interest rates near zero.

While those choices typically lead to inflation, that seems to be the least of the Fed's concerns at this point.

The specter of Japan's struggle with deflation is what worries many. The Asian nation has been stuck with slowly falling prices for the better part of the last two decades. Despite nominal interest rates of zero, Japan has still suffered trough mild rates of deflation.

As Bullard warns, "If we drift into that kind of outcome, I think it'll be very hard to get out."

Bullard suggests that we use the Treasury market for signs of deflation, particularly the market for TIPS (Treasury Inflation Protested Securities). If they were at two percent or higher, Bullard says he wouldn't be as concerned.

However, the five-year TIPS-based measure of expected inflation has recently fallen to about 1.4 percent.

"Right now thats not quite low enough to really get worried," says Bullard. "But if it starts to go, say, below one percent or lower, then you might be sliding toward this deflationary outcome."

The Japanese lesson is that once deflation starts, it's very hard to stop. Japan has tried many things to get out of this trap, and yet nothing has worked. After the better part of two decades, it still can't break deflation's grip.

That's what has so many people concerned here in the US.

Addendum: In a previous post, I discussed how Decreased Lending Is Shrinking The Money Supply

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