Did I Overreact When Worrying About Deflation?

by: IPE at UNC

by Kindred Winecoff

Last fall Dr. Oatley told me not to freak out about deflation as price indices fell despite the fact the Fed had dropped interest rates practically to zero. Since that time the Fed has engaged in unprecedented "quantitative easing" policies while keeping interest rates near the zero bound. Thankfully these actions, along with the bailouts and stimulus policies of the Bush and Obama Treasury Departments, have kept the American economy out of a deflationary spiral. The most recent data show a core CPI inflation rate (excluding energy and food prices) in the black.

So, was I overreacting? I don't think so. For one thing it was not clear back in November that the Fed would engage in quantitative easing, or that those actions would have much traction. It also was not yet clear how long the credit crisis would persist, what actions the Treasury Department would take, or what effect a stimulus bill that was still months away would have. In fact, some of those questions are still unanswered.

But one thing is clear. The ECB and Bank of Japan adopted less drastic monetary and fiscal policies than the U.S., and the result has been record-setting falls in their price levels. They are still not in end-of-the-world territory yet (especially in Europe), but they are firmly in the danger zone. As Dr. Oatley wrote back in November, this is cause for concern for following reasons:

1. Debtors suffer as the real value of their debt rises. Hence, more difficulties to service loans (think about housing price collapses and mortgage foreclosures). Rising debt service problems can harm financial institutions (that's an ironic understatement).
2. Creditors benefit as the real value of their assets rises. Of course, this assumes that debtors continue to pay.
3. Consumers benefit, because things get cheaper every day.
4. Not so good at the aggregate level. If we expect everything to be cheaper next month, we won't buy it this month. If we all defer our purchases in expectation of lower prices in the future, our aggregate demand falls and we produce less--which means we employ fewer people. With less income from lower production, prices fall further, so we push our big purchases off to the future again. And so on and so on. Deflationary spiral, I believe it is called. This is pretty much what happened in 1929-1933.