May 28 , 2003

From the Congress to the Federal Reserve to corporate board rooms, the talk increasingly is about deflation.  What is it?  Should we worry about it?  Is it approaching?

Some industries, such as semi-conductors have been facing deflation for years.  They begin their planning process by asking how much prices will fall.  They then use innovation from previously invested research and development, resource management, and new capital spending to assure the capacity to make a reasonable profit at those reduced prices.  They have shown that if you expect price declines, you can continue to earn profits when they occur. 

However, deflation is not some prices falling sometime or even all the time.  It is a general reduction in prices.  If prices of goods are falling one to two percent a year, but service prices are growing two to three percent, there is no general deflation.  However, the goods producing sector will be faced with financing problems that could create difficulties if the deflation is unexpected. 

Indeed, the greatest problem with deflation is that companies may have debts that are becoming more difficult to pay off as prices fall.  In the most severe instances, even lenders are struggling because debtors default on their loans.  Such defaults lead to reduced lending capacity that could lead to serious economic contraction, as in the 1930s, or to long term malaise, as Japan has been suffering in the past fifteen years. 

Deflation also undercuts the ability of the monetary authorities to support economic activity.  If prices are falling 3.5 percent, as they did at annual rates in the past quarter in Japan, then even zero interest rates mean that 3.5 percent production growth is needed to pay off any debt that is incurred.  This is an exceptionally high growth rate of production.  However, interest rates will not fall below zero, so borrowing and the expansion it generates does not occur. 

The loss of monetary authority, the prospects for malaise, and the risks to lending institutions make deflation an undesirable economic condition.

However, there are some winners.  They are the bond holders of debt instruments that are unlikely to default.  As deflation is receiving more attention, investors are shifting their holdings toward such investments (normally government bonds).  Those lowest mortgage rates in two generations are the result of deflation concerns. 

A little deflation for a short period of time probably is not too damaging.  Few companies are about to default on their debt because prices fell in April.  However, a persistent decline in overall prices will seriously risk the survival of heavily indebted companies.  Persistent deflation may be an even greater economic concern than persistent inflation.  Financial institutions can function in the inflationary environment but may be at risk if deflation caused too many loan defaults. 

Now that we see that deflation can be a serious economic risk, how likely is such an outcome?

A few years ago, I developed a set of indicators of inflationary pressures.  In fact, they were designed to anticipate price changes regardless of whether those changes were positive or negative. 

One measure, labor costs per unit of production, has been negative for some time.  To the extent that these reduced costs are the result of increased efficiency, as they were in the past couple of years, inflation will be restrained but economic activity will expand.  However, if the labor costs are being constrained because wage gains are slowing, then the capacity to sustain consumer spending may be eroding. 

In fact, wage increases are slowing, but not as dramatically as some magazine covers suggest.  Hourly earnings are increasing about 3 percent, about a percentage point less than two years ago, and are still slowing.  Productivity gains also are slowing, so the spending capacity of workers is slowing.  This is not a good sign, but the changes are not yet dramatic. 

Unutilized capacity is higher than at the low point of two of the previous three recessions.  This also is not a good sign.  On the other hand, an increasing amount of that idle capacity contains technology that is not even close to best practices.  Therefore, the ability of the unutilized capacity to exert downward price pressures is limited. 

Most significantly, crude material prices other than the volatile food and energy, fell sharply in the past month.  This is my most important inflation indicator, and that large 1.3 percent decline is not comforting.  Again, however, special circumstances can explain away most of the concern. 

First, tobacco leaf prices, which are included in this data, plunged.  Second, this was the first monthly decline after seven consecutive advances.  Third, the indicator is only significant after price changes have accumulated about 10 percent more than prevailing prices in the past six months.  At this point, the indicator actually shows some slight bias to price gains. 

Finally, the dollar's value dictates how much imported goods will cost over time and how much exports (and their domestic uses) can be raised in price.  Again, changes must persist for a long time (about three quarters) before any results should be expected.  Still, the dollar is falling sharply in value against other currencies.  If this continues, inflation might be the result. 

On balance, my indicators do not suggest that deflation is about to happen.  Indeed, the Federal Reserve probably is overstating the case for deflation versus inflation at the present time.  However, an interest rate decline at the June Federal Reserve meeting would have little risk of stimulating inflation.  Given all the deflation talk, that is probably the policy move that will happen. 


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