January 2003

Is Deflation in Store for 2003?

By ROBERT PEGG

With the consumer price index running at between one and two percent and with the producer price index negative in some recent months, there has been growing talk among some economists of deflationÑa general falling of prices.

For decades, inflation was deemed the more serious threat to the economy by the nation's policymakers and economists. Particularly worrisome now, however, is that prices appear to be sluggish in an environment of increased borrowing by American households to finance purchases of houses, cars and other luxury goods. In a deflationary environment, paying off the increasing debt load can wreak havoc on household balance sheets. A deflationary environment could increase the real burden of these debts, forcing consumers to sharply cut back spending.

Economic leaders in the U.S. and abroad have dismissed fears of a plunge toward deflation, reminiscent of the Great Depression of the 1930s. Price trends on many products suggest otherwise. They have fallen to historical lows and many products, from computers to clothing are significantly cheaper than they were one year ago.

A full-fledged deflation requires a persistent fall in the nation's overall price level. The recent decline in prices for durable goods has been offset by price rises in the service sector of the economy, particularly medical services. Nonetheless, measured by the gross domestic product price deflator (GDP deflator), the nation's best gauge of inflationary pressures, the inflation rate has fallen to 1.1 percent annually, its lowest level in 40 years. Moreover, within the consumer price index, prices have fallen in half of its 16 major product categoriesÑthe largest proportion since the series began.

Today, the world is inundated with excess capacity in industries from telecommunications to autos, airlines and banking. Until this excess is removed from the economy, downward pressures on inflation will persist. Some argue that deflation is far less likely today than the 1930s because services account for a larger share of the economy. Prices of services tend to be more resistant to decline than the prices of goods, because they are more labor intensive and wages usually do not fall very muchÑeven in a recession. However, the rate of service-sector inflation has fallen. The rate of increase in the service component of the GDP deflator fell three percent last year to 2.2 percent in the second half of 2002.

Other economists argue that while deflation poses a serious risk, incompetent monetary policies were largely to blame for deflation in the U.S. in the 1930s and today in Japan. A recent report by the Federal Reserve Board took lessons from Japan and argued that when inflation is unusually low, central banks around the world must be particularly alert to deflationary risks and cut interest rates by more than normally justified by inflation and economic growth.

Deflation is not always all bad. If falling prices are caused by faster productivity growth, as was the case in the 20th century in the U.S., then it can compliment robust economic growth. On the other hand, if deflation reflects a slump in demand and excess capacity, it can become dangerous as it did in the 1930s, triggering a downward spiral of demand and prices. Today, it appears that a combination is at work. Thanks to gains in information technology, some prices are falling because of productivity gains. However, profit weakness suggests that some of the deflation is unhealthy, particularly when the economy is overloaded with debt. Falling prices not only increase the real burden of debt, they make it extremely difficult for a central bank like the Federal Reserve to attain negative real interest rates, because nominal or current rates cannot drop below zero.

If deflation causes debts to balloon, debtors may have to cut spending and sell assets to meet payments. This situation can unleash a vicious cycle of falling incomes, lower asset prices and rising real debt. In this situation, unable to increase prices to boost profits, many firms may have to cut costs, which reduce aggregate income, or purchase less from other companies. This, in turn, reduces aggregate economic demand if enough companies pursue similar policies.

Fortunately, our central bank has been on top of the situation. With strong fiscal policies in place and the prospects of war, which is always inflationary, deflation is likely to be kept at bay.

About the author: Mr. Pegg is president of Kirkbride Asset Management, the New York City-based investment advisory firm which serves businesses, institutions and private individuals.