Sunday, March 6, 2011

Stop Worrying About Deflation

The Federal Reserve is running its monetary printing press day and night, desperately seeking to inflate the U.S. dollar. It may have accomplished its goal, at least outside the U.S. Oil, which is traded in dollars, has risen sharply in the past few months (starting well before the Arab unrest). Food prices worldwide have also risen. Global supply of food hasn't fallen. But increased demand for meat, poultry and other higher status foods, especially in China and the rest of the developing world, has strained supplies of grain, and pushed up the price of bread. It's probably no accident that the unrest in the Arab world was preceded by rising bread prices. It's tough to be complacent if you and your family are having trouble getting enough to eat.

In America, there seems to be little inflation. The Fed worries that deflation, even though it's not actually occurring, would lead consumers, hoping for lower prices later, to hold back on spending and retard the economic recovery. It asserts that Japan's meandering price levels are a cause for its economic stagnation. So the Fed keeps shoving bales of dollars off its loading dock. But this is a misadventure in misjudgment.

First, deflation today would help consumers. Household incomes have hardly risen for decades, and consumers react to higher prices by cutting back, not spending more. Rising gasoline and food prices discourage discretionary expenditures. Some people may swap a fuel hog for a gas sipper. But most can't afford to do that, so they just spend less on other things. Price deflation would increase their spending power and lift demand.

The last period of sustained deflation was in the 1930s. But that deflation was the result of the economic downturn, not the cause. Speculative financial and real estate bubbles, aggravated by misguided monetary policies, caused the Great Depression. Did deflation retard recovery from the Great Depression? There's not a lot of evidence of that. Joblessness, by all indications, was the primary factor holding the economy back. When employment rose as America geared up for World War II, consumer spending rose. (It was partially delayed by rationing during World War II, but there was a surge of consumer spending as the war ended which led to the postwar prosperity.)

Sustained deflation also took place during the Gilded Age (1865-1900), when prices dropped by roughly one third. This was a period of great economic growth. Although punctuated by financial bubbles and sharp recessions, the Gilded Age saw dazzling technological innovation (construction of municipal electrical energy systems, the telephone, improved steel manufacturing and oil refining, etc.), legal innovation (evolution of the general business corporation), and financial innovation (nationwide capital markets that featured vibrant secondary markets in common stock and corporate bonds). All this innovation spurred enormous growth. Income distribution was problematic, as business elites accumulated vast fortunes, often by forming cartels and monopolies, while workers struggled to get living wages and farmers combated monopolistic railroad freight rates. Price deflation was a gift to ordinary Americans trying to survive. The growth of mass market mail order retailers, like Sears Roebuck and Montgomery Wards, signaled that Americans of this era had little aversion to consumption in spite of falling prices.

The way the Fed measures inflation tints the lenses through which it sees a threat of deflation. The Fed's preferred benchmark is the Personal Consumption Expenditures Price Index (PCE). The better known Consumer Price Index measures changes in price of certain selected consumer items. For example, the CPI measures inflation or deflation in the price of name brand coffee by comparing the current price of that coffee against its past price. By contrast, the PCE incorporates substitution of products by consumers. If the price of name brand coffee rises, and consumers switch to less expensive supermarket house brand coffee, the PCE records lower inflation than the CPI because consumers avoided paying the price increase in name brand coffee by switching to lower cost house brand. The fact that drinking house brand coffee can sometimes be a near death experience isn't counted as inflation.

The PCE typically records about one-third less inflation than the CPI. So by focusing on the PCE, the Fed sees a greater potential for deflation. But the Fed's use of the PCE means that a reduction in living standards in response to rising prices doesn't count in the measurement of inflation. That notion would be a hard sell to shoppers facing the daily realities revealed on grocery store shelves. It also means that the harder the Fed tries to instill inflation, the lower it might push living standards as consumers substitute cheaper and cheaper goods when their preferred choices become costlier as a result of Fed inflating. Perhaps the Fed should consider that forcing people to substitute sawdust for bread might snatch defeat from the jaws of victory.

The primary reason why people consume or don't is confidence in the future. Moribund consumption in Japan is due to Japan's uncertain future. Younger Japanese adults face dismal employment prospects, often limited to temporary jobs instead of the lifetime employment contracts given their parents. Since younger adults tend to consume with vigor, their lousy employment picture dampens economic growth. (Older Japanese are actually spending more as they tap into their savings for retirement, but this hasn't made up for the reticence of the young.)

No matter how much the Fed inflates prices in America, people won't consume deliriously if they fear layoffs. Using your old washer and dryer for a while longer makes sense of you're trying to reduce debt and build up an emergency cash fund. Spending like the maniacal days of 2005 doesn't make sense if your house looks like it's headed for a double dip in value. The Fed thinks that rising prices will scare people into spending. Rising prices do scare people. But, in these uncertain times, they scare people into pulling back. A little deflation would come as a relief.

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