Deflation may become the new normal

  • Article by: CHRIS FARRELL , American Public Radio
  • Updated: October 23, 2010 - 10:54 PM

It goes without saying that these are trying times. Sure, the economic mandarins at the National Bureau of Economic Research pronounced that the recession ended 16 months ago. And it goes without saying that it's better to be growing than shrinking.

Still, that's cold comfort to the more than 26 million workers out of a job, involuntarily working part-time, and marginally attached to the job market. Home prices are down about 30 percent since the mid-2006 peak and it's likely that additional price declines lie ahead.

Low interest rates helped shore up banks' balance sheets over the past two years, but they also sharply sliced into the returns of savers.

As if all that weren't enough, the specter of deflation is haunting the Federal Reserve. Inflation is a sustained rise in the overall price level. Deflation is its mirror image, a widespread, persistent decline in the average price level. The so-called core personal consumption expenditure price index -- a favored broad-based price measure at the Fed that excludes volatile food and energy -- is down from a 2.5 percent annual rate early in the recession to about a 1.1 percent pace over the first eight months of 2010. The prospect of deflation isn't easily dismissed.

Here's the thing: Inflation is the money condition we know. Deflation is an unfamiliar, unsettling state of affairs -- with good reason. America's most notorious episode of deflation was also its last -- the Great Depression. What are the implications for managing our money?

Like all money matters, it's complicated. But the big issue to highlight is that deflation rewards savers and penalizes borrowers. The real cost of debt goes up during deflations. The rising cost of meeting principal and interest payments on debts is one reason why so many businesses and households run into financial trouble during deflationary episodes.

The reason? You're paying the lender back with increasingly valuable dollars. In contrast, with inflation you're repaying the banker with depreciating dollars. The reward to savings is that eventually your money buys a lot more than before. An analogy would be the long-term deflation in personal computer prices. Every year computer prices are lower than the previous year and, at the same time, you're buying a more powerful machine.

It's also important to realize that not all deflations are the same. Hyper- deflation, say a 1930s deflation rate of 5 percent to 10 percent, is ruinous. The record is mixed when it comes to mild deflation, say 1 percent a year. Mild deflation can be bad if it stems from a "demand shock" such as the credit crunch of 2008 and the Great Recession. But sometimes mild deflation can signal a vigorous, healthy economy. Good deflation can co-exist with strong economic growth when the primary cause is a "supply shock" coming from a string of major technological innovations and productivity improvements.

The deflationary pressures we're witnessing right now largely reflect reverberations from the recession. But my suspicion is that the global spread of capitalism suggests that the disinflationary-to-deflationary price level is the new normal. In that case, we'll all have to learn how to manage our money in deflationary times, both good and bad.

Chris Farrell is economics editor for American Public Media's "Marketplace Money." Send questions to cfarrell@mpr.org.

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