November 21, 2001



In the past week or so, some economists have begun to talk about global deflation.

The latest evidence on prices is that they are falling in most sectors other than health. Prices received by farmers in October fell by the greatest amount ever recorded in a single month. The PPI showed the largest monthly decline in its history. Crude sensitive prices, an indicator of price pressures, showed a large 1.7 percent decline, although that followed a small increase in the previous month.

Although oil prices are no longer falling, this is only because oil producers are trying to slash another 1.5 million barrels a day from production. That is their third production reduction this year, and they still cannot keep oil prices above $25 per barrel.

Wages are continuing to rise, but the gains are at slowing rates. Indeed, productivity gains are almost as robust as the wage increases.

Such price cutting is not surprising. Inventories remain above desired levels and fell more slowly than sales during September. (Inventories probably declined sharply in October, however, as retail sales rebounded in that month). Price incentives are being used aggressively to sell excess merchandise while customers are coming to the stores for holiday purchases.

Also, production capacity has been falling. If producers can get more than the costs of producing new batches of product, they will operate, even if they cannot cover the notes outstanding on the equipment. Some of the strong auto incentives were precisely for this purpose.

Reduced demand for travel has spawned discounting of cruises, air trips, hotels and auto rentals. Excess office space has generated rate reductions there. Apartments are emptying as tenants are seeking homes because of the unusually low mortgage rates. Thus, rents are beginning to fall.

Because the world's economic growth is slowing sharply, production abroad increasingly is being sold into the United States. Because the dollar remains strong against other currencies and has just reached a high with our top trading partner, Canada, these goods enter our country with reduced dollar price tags.

Economists always knew that excess inventories, rising excess capacity and a strong dollar could combine to cause price declines. Should we be worried? Also, how long will prices continue to fall?

In Japan price declines have become expected by consumers. Because they expect goods and services to be cheaper tomorrow, they do not spend on them today. Also, falling prices usually mean eroding profit margins for companies. With such poor returns on their invested capital, businesses are reluctant to spend on more capital.

Even government tax receipts are under pressure when prices fall. Deficits rise and government spending or tax cutting initiatives are curtailed. Just think what happens to sales tax receipts when prices fall. Deflation is far from a blessing for most state and local governments.

Price declines are especially difficult for financial institutions. They have issued loans supported by the market value of assets. If those values fall, the support for those loans erodes. Defaults rise, and in the worst case, banks lose the capacity to make loans. After a year of declining prices in 1930, bank failures added to the economic weakness of the Great Depression.

Deflation certainly is an interesting problem. It is creating policy difficulties in Japan. When prices are falling nearly 2 percent per year, even zero interest rates may be too high to encourage investment in that country.

However, price declines increase the purchasing power of those who have assets that are not losing their dollar values. Falling prices cause interest rates to decline. This raises the value of quality bonds. Housing prices may remain high while refinancing of mortgages allows homeowners to save money on their monthly mortgages.

Eventually, that additional purchasing power will be spent. Indeed, the auto financing incentives aided a sharp retail sales rebound in October. Reduced auto inventories may require additional production soon to restock dealer showrooms.

Indeed, I would be surprised if prices continued to fall beyond November. Therefore, any adverse side effects from the current episode of price deflation should be minimal.


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