Anxiety over deflation is wide-spread and increasing. The New York Times lead editorial on Sunday warned that weakening commodity prices may be a harbinger deflation or a hint of economic decline. Despite a few contrary voices, both policy makers and investors seem concerned. Are the fears misplaced? Or would deflation be a large step backward?
The chart shows 101 years of American inflation measured by the CPI.
Prices move all the time – not just stock prices but prices of almost everything in the economy. Deflation is when prices, usually measured by an index like the CPI, consistently fall. Inflation is the opposite, prices rise. Largely, but not completely, inflation and deflation are mirror images of one-another; for now call them flation. If flation’s movements aren’t too sudden, surprising or violent and if everyone anticipates them, the damage would be minimal. Anticipation is important because financial contracts often specify payments made over time and rarely adjust the payments for flation. When prices rise, goods and services cost more but money is worth less; in deflation prices fall, goods and services cost less and money is worth more. If everyone expected 5% inflation and all existing and future loans, bonds, contracts and agreements reflected 5% inflation – and the prediction came true – no one would be hurt by inflation. Bond holders and other lenders would be compensated for the falling value of money with higher interest rates. Prices and wages would smoothly adjust. For a visitor from a foreign country with stable prices the only hints that things were different would be seemingly high nominal interest rates and a falling currency. Of course this no-pain world of 5% inflation cannot exist – inflation expectations won’t be universal, predictions won’t always come true, prices will depart from their expected path and policy makers will keep changing the game plan.
There are some differences between deflation and inflation. An economy of fully anticipated deflation would be worse than one of anticipated inflation. First, interest rates can’t go below zero – if some tells you that if you deposit money in a bank, the bank will pay you -5% interest — take 5% of your money and not give you anything in return – you’ll hold on to your cash. Suppose prices are falling 5% per year and government bonds pay 1%. The deflation-adjusted return on the bond is 6% and it is risk free. Risky investments don’t look very attractive when the risk free real rate of return is boosted by deflation. Deflation at 1% or 2% might not be a huge impediment to investing, but flation is rarely stable. As investment dries up and the economy slumps, 2% deflation will become 4% or 6% or more. When prices fall, the best investment is often holding on to your money – its works best by not working at all.