Headline: For the First Time Since Ike, a Whiff of U.S. Deflation

Source: New York Times, 2 November 2001

URL: http://www.nytimes.com/2001/11/02/business/02NORR.html

DEFLATION. To a generation raised to fear inflation, the opposite — prices falling across the economy — has a certain attraction. Paying less must be good.

There is a catch, of course. Your costs are someone else's income. And when income is falling it creates all kinds of problems for the economy and makes it harder for monetary policy to stimulate growth. Prices fell during the Depression, and they are falling now in Japan. Neither provides a model that anyone wants to emulate.

And now one measure shows deflation is here.

The government's quarterly growth report, which showed that the economy shrank in the third quarter, reported a decline of 0.4 percent, at an annual rate, in prices for personal consumption expenditures. It was the first quarterly fall in nearly half a century, since the second quarter of 1954, at the end of a recession.

The number is calculated in a more sophisticated way than the more widely followed consumer price index, and it is a figure that the Federal Reserve watches. Fed chairman Alan Greenspan prefers the core figure for personal consumption expenditures, which excludes food and energy. It is still barely positive, at 0.3 percent.

To be sure, part of the collapse in inflation reflects recession-induced price cutting, which is normal. But there have been seven recessions since 1954, none of which brought deflation.

What is new here is that deflation is spreading from the industrial world to consumers. The Commodity Research Bureau index of raw industrial prices peaked in 1995 and now is at a 15-year low, off 16 percent this year and 40 percent from its high. Yesterday's report from the National Association of Purchasing Management showed the pricing power of manufacturing companies is at its lowest level since 1949.

There are winners from deflation. The fall in gasoline prices amounts to a tax cut, which the economy can certainly use. But as the Japanese experience shows, enduring deflation can lead to a big drop in consumption, as consumers conclude that prices will only get cheaper. Cutting wages is very hard to do, so corporate profits get squeezed, leading to more layoffs and more drops in consumer purchases, which lead to more layoffs and on and on.

The classic way to fight such a weakening economy is by easing monetary policy. But to be stimulative, the Fed needs to get short-term interest rates below the inflation rate. "The liquidity trap in economic theory arrives if the inflation rate falls below zero," said Robert Barbera, the chief economist of Hoenig & Company. "You run out of bullets before the inflation rate hits zero."

Lower interest rates this year have kept the housing and auto sectors from collapsing, as they usually do early in economic downturns. But housing has started to weaken. "It now appears that a downward path of housing prices will accentuate the negative wealth effect from the stock market's decline," said Dean Baker, co-director of the Center for Economic and Policy Research in Washington.

A decade ago, Japan's central bank was slow to loosen credit after its bubble burst. There is no way to prove its reticence was the cause of Japan's malaise, but it did not help. It is a precedent that Mr. Greenspan surely recalls.

The whiff of deflation is just one more reason that rates need to fall further. When the Fed meets next week, anything smaller than a half-point cut in the Federal funds rate, now 2.5 percent, would send the wrong signal. Another cut in December will probably be wise as well.

-- Andre Weltman (aweltman@state.pa.us), November 02, 2001

Answers

The Fed is fast approaching the time is will run out of ammo. If we ever get the point Japan is at, look out. It would be like a dog chasing its tail.

-- Wellesley (wellesley@freeport.net), November 02, 2001.