Deflation Threat Remains

The very tepid economic recovery has economists in developed countries pondering the prospects for deflation. Deflation is a general decline in the price of goods and services. Everything becomes less expensive. So, why the worry?

Deflation is typically caused by a decrease in consumer, government and investment spending. There has not been a period of sustained falling prices in this country since the Depression in the 1930s. In fact it is so rare that economists have not had many opportunities to study it in real time.

In Europe and the US, consumers are paying down debt, cutting their spending and saving more. Many countries in the European Union, afflicted with large national debts and budget deficits, are also being forced to cut back on spending. The result of this belt-tightening is a slow down in price increases. The Wall Street Journal reported this week that “excluding volatile food and energy sectors, consumer prices [in the US] were up just 0.9% in May, the smallest increase since 1966.”

Government policy makers find combating deflation very difficult. Traditional policy tools are designed to fight inflation, not deflation. Central banks can’t lower interest rates, because they are already almost zero. Government spending will only exacerbate budget imbalances and increase sovereign debt levels. Consumers will put off purchases, if they expect prices to be lower in the future. This further compounds the problem, as prices have to drop even further to entice consumption.

Lower prices lead to economic contraction. Wages fall, incomes drop, spending falls further, and on it goes. It is a downward spiral that can result in a reduction in overall economic welfare.

Let’s hope we don’t face a serious prospect of deflation, because the Federal Reserve has a very limited ability to do anything about it.