Deflation

Deflation is a sustained decline in prices across the entire economy. Deflation is the opposite of inflation (rising prices), and is usually related to economic recession and stagnation. Central banks seek price stability in an economy, and typically try to prevent deflation before it starts. There are fewer tools to deal with deflation once it becomes entrenched, as will be shown.

Measuring Deflation

Broad-based price indexes such as the Consumer Price Index (CPI) can indicate deflation when registering ongoing declines. However, these indexes can vary month over month due to volatile costs such as fuel and food. Some economists remove these volatile costs from their assessments and focus on the core prices for a truer assessment of an economy's overall tendency towards inflation or deflation.

It should be noted that declining prices in one product sector due to production efficiencies (such as the long-term price declines for mass-produced goods such as computers or flat-screen televisions) need not be indicative of overall deflation; deflation only becomes an issue when prices have fallen across the economy over a sustained period of time.

A related term is disinflation, which is a decrease in the rate of inflation such that prices stop going up. Disinflation turns into deflation if prices continue dropping over a sustained period.

Effects of Deflation

When the phenomenon of falling prices occurs across an economy for a sustained period, there can be stark consequences. As prices fall, consumers expect them to fall further, and delay purchases. (Why buy now, when it could be cheaper next week?) If there's a corresponding recession, consumers may also stop spending to focus on paying down debts or increasing savings. Reduced consumption (reduced demand) leads to overcapacity (oversupply), thereby idling or reducing investment in production. Reduced production in turn leads to layoffs, economic stagnation, and further reductions in demand. If left unchecked, this phenomenon leads to a deflationary spiral that is hard to break out of.

Deflationary spirals can lead to economic protectionism, either because of populist sentiment or because of necessity. Without money to buy, the population tends to barter or use alternative currency arrangements that encourage local production. Governments may also discourage imports or use other protectionist measure in an attempt to revive their economies.

Causes of Deflation

Increased supply-decreased demand, with economic contraction or contracted money supply

The traditional supply/demand curve can explain the root causes of deflation: downward price movement results from either falling demand (due to economic stagnation and associated consumer reticence to purchase), or increased supply (due to overproduction or production advancements as during the Industrial Revolution).

In typical supply/demand situations, a drop in price leads to increased demand. In deflationary times, however, demand does not increase due to lack of consumer confidence and economic contraction. The economy must then be stimulated to increase the money supply to drive demand, through either government fiscal policy or central bank monetary policy.

Some of the more severe periods of deflation were during times when the authorities chose not to increase the money supply to counter deflation. For example, the Industrial Revolution during the 19th century created spectacular increases in production efficiency—an oversupply—but coincided with a relatively flat money supply, causing a deflationary cycle. By contrast, the early years of the Great Depression (1929-1933) witnessed large drops in demand, yet governments of the time stubbornly stayed the course to reduce their debts, thereby reducing the money supply. It took some drastic measures after 1933 when Franklin D. Roosevelt came to power (including a forced devaluation of the price of gold by 40%) to increase the money supply and halt the deflationary spiral. ^[1]

Debt

Irving Fisher was one of the most bullish of spokespeople during the boom times in the late 1920s, and lost both money and reputation after the crash of October 29, 1929. He later argued in a seminal essay^[2], “Debt-Deflation Theory of Great Depressions” (1933) that debt is one of the main causes of the type of deflation associated with boom and bust cycles.

Fisher argues that economies create cyclical “oscillations” that encourage new opportunities to invest and invent. These opportunities sometimes create booms that lead to speculation and a corresponding willingness in the population to accumulate debt in order to participate in this speculation. When the population becomes conscious of its over-indebtedness and attempts to liquidate, falling prices or over-inflated currencies can quickly result. Unless there are active efforts to stop the resulting deflation, the increasing drive to liquidate only serves to aggravate the debts, and the deflation (and the bust) grows worse. Fisher concludes that the only ways out of this bust cycle “are either laissez faire (bankruptcy) or scientific medication (reflation).” However, he warns that “reflation” (in modern terms, increased money supply, reduced taxes, or other fiscal or monetary tools) may only serve to delay deflationary problems if the underlying debt is not addressed. ^[3]

Psychology

Once deflation starts and is left unchecked, the population develops a mindset to delay purchases, curtail investments, and attempt to liquidate assets (cash being the only certain vehicle that will increase in value over time). This psychology of liquidation exacerbates deflation and can contribute to a deflationary spiral (that is, perfectly good assets are devalued, equity prices fall, investments falter, unemployment rises, the population further curtails spending, and the cycle starts anew). It is difficult to counter this psychology once it sets in.

Some Past Periods of Deflation

1800s and the Industrial Revolution

The 1800s witnessed numerous deflationary cycles in the United States: the recession of 1836, The Great Deflation after the Civil War, and “The Great Sag” of 1873-96. The Great Sag had a global scope, and featured incredible advances in technology (the Industrial Revolution) that lead to unprecedented cost-cutting and productivity-enhancing technologies—an increase in the supply of goods that caused downward pressure on prices. Because the money supply was kept flat during this time, there was a deflationary cycle that caused tremendous deprivation to a large number of people. ^[4]

The Great Depression

The Great Depression began with the stock market crash on October 29, 1929, after a period of economic boom and speculation. In the United States in the period from 1930-1933, equities prices in the United States fell 10% per year and unemployment increased to 25%. ^[5]

The government of J. Edgar Hoover stayed a course of debt reduction and other conservative fiscal measures, thereby reducing the money supply further. It took some drastic measures after 1933 when Franklin D. Roosevelt came to power (including a forced devaluation of the price of gold by 40%) to increase the money supply and halt the deflationary spiral. Current Fed governor Ben Bernanke is an expert on the Great Depression, and has developed various stimulative economic theories to prevent a prolonged deflationary period such as occurred during the Great Depression. He is currently applying these theories in his role as Fed chairman.

Japan 1990s

Japan suffered a prolonged “lost decade” after an asset bubble burst in 1990. By 1991, Japan's housing prices had imploded, precipitating a sharp decline in bank assets. Customers' bank deposits were guaranteed by the state, forestalling a run on the banks, but the banks remained in prolonged crisis due to a lack of capital. The government was reluctant to provide taxpayer funds to help the banks, due to hostile public opinion, so the banks continued to struggle throughout the 1990s.

The Bank of Japan tried various monetary policies to counter deflation, especially when things got even worse in the late 1990s. Interest rates were held at zero percent from March, 1999 to August 2000, then the Bank attempted to add liquidity through quantitative easing—a monetary policy aimed at increasing the money supply and reducing long-term interest rates by setting aggressive targets for open market operations.

Methods for Fighting Deflation

Most economists agree that prolonged deflation is a bad thing and, if left unchecked, can lead to a deflationary spiral that cause economic stagnation, unemployment, and even social unrest as real debts become larger and larger.

Preventing deflation

The easiest way to fight deflation is to make sure it doesn't happen. In a speech to the National Economist Club in 2002^[6], Ben Bernanke (current Federal Reserve Chairman) spelled out several policies central banks must use to avoid deflation :

• Aim for a positive inflation rate (typically 2%) rather than trying to push inflation down all the way to zero.

• Ensure financial stability in the economy with a healthy, well capitalized banking system and smoothly functioning capital markets.

• If economic fundamentals deteriorate in periods of low inflation, act pre-emptively and aggressively to cut interest rates.

The zero-bound problem

In deflationary times, real interest rates are lower than the Central Banks' nominal rates (the reverse of normal inflationary times). Central banks must therefore drop their nominal rates quickly and proactively to rekindle inflation—preferably before deflation sets in.

During times of deflation, even a zero percent nominal rate is in effect a negative real interest rate (the nominal interest rate minus the inflation rate). Because the nominal rate cannot be dropped any lower than zero (the “zero bound” problem), central banks and governments must consider other approaches when interest rates are removed from their traditional monetary policy arsenal.

Curing deflation

When faced with the zero-bound problem, governments and central banks must introduce liquidity into the economy using methods other than dropping the interest rate. These methods tend to involve fiscal policies (increased government spending) rather than traditional monetary policies practiced by central banks.

“Printing money” (aka Quantitative Easing)

Bernanke states in his 2002 speech that the easiest way to rekindle inflation is to increase the money supply in circulation (or even threaten to do so). In previous times, this would involve printing and distributing more paper money. In today's electronic world, other methods are required, the most common being the purchase of assets by the central bank. This method, sometimes known as quantitative easing, is a monetary policy aimed at increasing the money supply (liquidity) by setting aggressive targets for open market operations performed by the central bank.

Quantitative easing was attempted by the Bank of Japan from 2000-2006, when the central bank set targets to increase its current account balance by purchasing long-term Japanese government bonds (JGBs) and other money market instruments held by commercial banks. With commercial banks parking their excess reserves at the Bank, effective interest rates for the interbank market could remain at or near zero, thereby encouraging lending.

In his 2002 speech, Bernanke hinted at several quantitative easing type strategies the US Federal Reserve could use to help introduce liquidity:

• Expand the scale of asset purchases or expand the types of assets that it buys

• Strengthen aggregate demand by lowering the rates for longer-term maturities. This could be accomplished by holding the overnight rate at zero for some specified period by committing to make unlimited purchases of securities or by announcing explicit ceilings for yields on longer-maturity Treasury debt.

Central bank loans

If working with the financial institutions to introduce liquidity into the market is not effective, Bernanke argues that the next step is for the central bank to buy securities directly from the private sector, or make low-interest-rate loans to banks so they will lend to the private sector.

The Federal Reserve also has the authority to buy domestic government debt or even foreign government debt (although buying foreign liabilities may affect the value of the US dollar, and the Fed does not have the authority to influence the value of the US dollar. The Department of the Treasury has this authority, but as at 2002, according to Bernanke, was determined to avoid disrupting free market forces.)

Fiscal policy

If the central bank has exhausted all possible monetary policy initiatives, the government (in the USA, the Department of the Treasury) must work with the central bank to introduce fiscal policy that helps to introduce liquidity into the market. Bernanke lists some examples: broad-based tax cuts, open-market purchases to prevent rises in interest rates, increased government spending on goods and services through infrastructure or other programs, acquisition of real or financial assets, and so on.

Current Times

Are we entering a deflationary period?

As recently as September, 2008, most central banks (with the exception of the Bank of Japan) were still concerned with inflation. As of November, 2008, the word “deflation” suddenly appeared in the media and has become a favorite topic of economists and politicians.

Broad-based price indexes for the month of November, 2008 indicate declines in the month-to-month inflation rates for many countries (USA -1.7%, Germany -0.5%, the EU -1.1%, the UK -0.1%, Canada -0.3%). This is the second month of declines, so could be considered indicative of disinflation. The annual inflation rates for most countries remain in positive territory (USA 1.0%, Germany 1.4%, the EU 2.1%, the UK 4.1%, Canada 2.0%). ^[7]

Month-to-month core inflation rates (which exclude the price of oil and food) paint an even better picture (November, 2008: USA 0%, the EU 2.2%, the UK 2.0%, Japan 0.2%, Canada 2.4%). ^[8] When food and fuel are removed from the figures, the prospect of deflation doesn't seem to yet exist. Note that the rapid fall in the price of oil in itself will ensure a year-on-year drop in broad-based inflation rates for months to come (especially over the summer of 2009).

On a more anecdotal level, there are certainly deflationary symptoms: liquidity is an issue, so banks are reluctant to lend money (causing further money supply problems). (See [Forex Blog commentary].) Consumer confidence is shaken, with a strong fear of losing jobs, investments, pensions, savings, and so on. The lack of demand has led to inventory gluts of automobiles and consumer products, indicating further downward price pressure. ^[9] Commodity prices continue on a downward trend, with the spot price for oil down over 2/3 since the summer of 2008. ^[10]

Government reactions

The US Federal Reserve and their Treasury department counterparts seem to be fighting the spectre of deflation using Bernanke's playbook (as outlined in the section above, Methods for Fighting Deflation). As of December 19, 2008:

• They lowered the Federal Fund Target rate to 0.25%.

• Through the Troubled Asset Relief Program (TARP), they've lent money to banks (or even acquired banks) as a way to ensure liquidity to the markets.

• They are now considering bypassing the banks to pump more liquidity directly into the market (for example, through company bailouts of auto manufacturers).

• Keynesian monetary policy, including infrastructure program spending, is being considered or proposed by the current Bush administration and the upcoming Obama administration (to be inaugurated on January 20, 2009).

Other nations have also reduced their interest rates recently, and have introduced stimulative efforts to help their respective economies counter deflation:^[11] As of December 19, 2008:

• The Bank of England has lowered its Official Bank Rate to 1.5% (from 5% in September) and the government of the UK has engaged in much stimulative spending.

• The ECB has acknowledged “disinflation” (for the first time admitting that inflation is no longer a problem) and has lowered the Minimum Bid Rate to 2.0% (from 4.25% in September). Its member governments are now assembling various fiscal stimulus packages.

• The Bank of Canada has lowered its overnight repo rate to 1.0% (from 3% in September), and the government of Canada has stated that it will go into deficit for the first time in many years.

• The Bank of Japan has lowered its already low Discount Rate to 0.1%.

Some possible explanations

Should the economies of the world slip into deflation, there are several possible explanations:

• There is a money supply (liquidity) problem caused by the sudden unravelling of many recent financial “innovations” (subprime mortgages, credit default swaps and other derivatives, and so on). Attempts by governments to use traditional monetary policy to increase liquidity have so far not worked.

• If you subscribe to Fisher's debt-deflation theory, the large accumulation of government and private debt in many Western countries could be a major cause of current deflationary tendencies. ^[12]

• The rapid pace of technological innovation and globalized production in recent years—in effect, another industrial revolution—has created excess supply that has outstripped demand. (One would have to consider recent failures in demand as temporary aberrations to accept this as a long-term explanation.) ^[13]

• Non-stop media coverage and political pronouncements on the economic slump have contributed to a climate of fear and corresponding drop in consumer confidence, increasing the possibility of a deflationary spiral.

Ramifications of deflation to currency markets

The following observations are speculations on how global deflation may affect various major currencies:

The USD

The United States may suffer a protracted period of deflation, given its large national debt, over-indebted consumers, and the recent asset bubble burst. However, the USD remains the world's reserve currency so enjoys a "flight to safety". It is questionable if the USD will continue to sustain its strength against other currencies because of a very low Federal Fund Target Rate and an onerous national debt that will only get worse with further government economic stimulus packages. Despite its stated policy, the US government may also be tempted to deflate the currency as one method to introduce liquidity into its market.

With an exceedingly low interest rate, speculators may also be tempted to use the USD as a carry trade vehicle, adding additional downward pressure. (See Forex Blog Commentary.)

The Euro

Inflation in the EU promises to be more “sticky” than elsewhere ^[14] so the ECB still has some breathing room to counter “disinflation” with monetary policy. Its legal mission is to fight inflation, so deflation will pose some problems because the mechanisms to fight it are not in place. If fiscal measures are required, the disparate economies in the EU will pose challenges to a coordinated fiscal policy, and there remain questions over whether or not the European partners can act cohesively in crisis mode.

The Pound

The UK has suffered a larger asset bubble burst than most, so is in for rough deflationary times. (The fall of the GBP reflects this sentiment.) Some commentators are alluding to Tokyo-on-Thames, in reference to the prolonged deflationary period in Japan. ^[15]

The Yen

Japan is already suffering from long-term deflation, but there will be fewer exports this time around to sustain its economy (and less government incentive is possible given a large government debt). The rising yen will also weaken exports, causing economic distress. However, Japanese consumers and businesses have fewer private debts and higher savings, so the country has the liquidity to weather deflationary times. The recent strength of the Yen is a reflection on Japan's underlying fiscal strength, and of the unwinding of the carry trade. Should the carry trade resume, the Yen will not be the only currency with low interest rates so the downward pressure will not be as pronounced.

The Canadian Dollar

The commodity currencies will be affected adversely by lower commodity prices. Canada's economic dependence on the USA will affect its economy and possibly consumer spending habits, leading to deflationary pressure. However, last year's strong Canadian dollar has already had the effect of pushing down prices (and the recent weakness of the CAD will increase prices for Canada's large number of imports).

Related Links

Inflation

Monetary Policy and the Role of the Central Bank

Managing Economies in an Era of Low Interest Rates

References

1. ↑ “Deflation: Making Sure “It” Doesn’t Happen Here”, Ben S. Bernanke, remarks before the National Economists Club, Washington, November 21, 2002
2. ↑ “Debt-Deflation Theory of Great Depressions,” Irving Fisher (1933)
3. ↑ For an opinion on how Fisher’s theories might be applied to today’s economy, see “Fisher's Debt-Deflation Theory of Great Depressions and a possible revision”, "London Banker" blog, 31 July 2008.
4. ↑ Wikipedia, Deflation
5. ↑ Wikipedia, Deflation
6. ↑ Bernanke.
7. ↑ FXEconostats and (for Germany) Statisches Bundesamt Deutschland
8. ↑ Japan reports core inflation rates; Europe typically reports broad-based inflation rates. European rate quoted in the Guardian; UK rate quoted here
9. ↑ “A Sea of Unwanted Imports”, Matt Richtel, The New York Times, November 18, 2008.
10. ↑ See FXEconostats
11. ↑ FXEconostats
12. ↑ “London Banker” blog makes this argument.
13. ↑ “A new economic era : A global shift to deflation,” Eisuke Sakakibara, May 22, 2003
14. ↑ “Depressing times”, The Economist, November 13, 2008
15. ↑ “What role would banks play in a period of deflation?”, Paul J Davies, Financial Times, November 22 2008