The U.S. economy has all the ingredients—slowing job and wage growth, slack consumer demand—for a deflationary cycle, without strong financial markets to cushion the blow
When policymakers at the Federal Reserve voted to slash interest rates at their Oct. 28-29 meeting, it's a good bet the threat of deflation played a role in the decision. That concern is bound to get more attention in coming months as inflation begins to fall amid a progressively weaker economy and the financial crisis. Deflation is an economic disease caused by a sustained drop in overall demand and falling prices that forces businesses to cut prices ever deeper. It was last seen in the U.S. in the 1930s and in Japan in the 1990s, when the inflation rate fell to zero and then turned negative for several years.
Deflation is a nasty situation that can give central bankers palpitations. It's especially onerous for borrowers. Because prices are falling, people who already owe money have to pay back loans in dollars that will buy more goods than the dollars they borrowed. For new loans, it raises the real, or inflation-adjusted, cost of credit, the opposite of what monetary policy needs to do to combat falling demand. Plus, in the effort to boost spending, policymakers cannot cut the target rate below zero. At that point, negative inflation can keep the real rate high enough to restrict economic growth.
The risk of deflation is small but not at all trivial. The last threat in the U.S. followed the tech bust and recession in the early 2000s. Back then, the Fed fought off what it euphemistically called "an unwelcome substantial fall in inflation" by cutting its target rate to 1% and keeping it there for a year. But the power of those rate cuts was aided by a strong financial sector. As then-Fed Governor Ben Bernanke said in a 2002 speech: "A healthy, well-capitalized banking system and smoothly functioning financial markets are an important first line of defense against deflationary shocks."
Without that backstop this time, the U.S. faces a new round of deflationary forces. All of the factors that fueled earlier inflation worries have sharply reversed course: Consumers are retrenching. Job and wage growth are weakening at faster rates. The stronger dollar is pushing down import prices. Oil prices have plunged, and even excluding oil, commodity prices have collapsed. Cheaper oil will magnify the coming slide in overall inflation. Yearly consumer inflation peaked at 5.5% in July but is set to fall to close to zero by early next year. Still, prices outside energy and food will determine whether broader inflation may be falling too rapidly.
The danger there, also unlike in the early 2000s, is that U.S. demand is falling outright. It fell sharply in the third quarter, and consumer confidence hit an all-time low to begin the fourth quarter. Asset-price deflation is especially corrosive. Since their peaks, the Wilshire 5000 stock index has fallen 40% despite the Oct. 28 surge, and the Standard & Poor's Case-Shiller Home Price index is down 20%.
Those declines are part of a broad deleveraging by financial firms and households. This forced casting off of debt is fueling the sale of homes, stocks, and other securities at fire-sale prices while shutting off new lending in a self-reinforcing spiral that destroys wealth and depresses demand. The virulence of this deleveraging process makes this business cycle even more susceptible to deflation.
The Fed's efforts to keep deflation at bay are already massive. Through Oct. 22 it has lent some $700 billion to bank and nonbank institutions. That's apart from the Treasury's $250 billion injection of capital into banks and its planned purchases of illiquid mortgage-related securities. Plus, rate cuts, totaling 4.25 percentage points since September 2007 and including the half-point reduction on Oct. 29, have taken the target rate down to the same 1% it hit earlier in the decade.
The problem: While credit markets are starting to thaw, they are still sufficiently dysfunctional to prevent the demand-boosting effects of rate cuts from reaching the economy. Until they do, deflation will be a threat that could force the Fed into even more unconventional policy efforts in 2009.