What’s so bad about a little deflation?
As Federal Reserve policy makers gather today and tomorrow in Washington to take the economy’s pulse and assess their policy course, prices will be on their mind. Specifically falling prices.
Not that deflation is a reality right now. The core consumer price index, which excludes food and energy, rose 0.9 percent year over year in both April and May, the smallest increase in 44 years. The Fed’s preferred inflation measure, the core personal consumption expenditures price index, rose 1.2 percent in the 12 months ended in April.
What the U.S. economy is experiencing is disinflation, a slower rate of price appreciation, not deflation, or falling prices. A little bit of the latter wouldn’t be the worst thing.
For starters, if the Fed wants to make good on its pledge of price stability, one of its dual mandates, it will have to do better than its 1.5 percent to 2 percent unofficial target. A 2 percent annual rate of inflation equates to a 48.6 percent increase in the price level over 20 years. In 35 years, the price level would double.
Anyone doubting the math should take a look at the effect the Great Moderation in inflation has had on the U.S. dollar. Every month, the Bureau of Labor Statistics includes the purchasing power of the consumer dollar at the bottom of Table 1 of the CPI report, using either 1982-1984 or 1967 as the base year.
Less Bad News
Let’s start with the good news. A 1982-1984 dollar bought 46 cents of goods and services in May. Granted, inflation was still high in 1982 and didn’t drop to 2 percent until 1986. Still, a loss of more than half of the dollar’s purchasing power doesn’t constitute price stability.
The bad news is that a 1967 dollar buys 15 cents today.
For every year inflation overshoots its target, the Fed should allow an undershoot if it is serious about price stability. Otherwise, its price policy is asymmetric.
“There’s nothing wrong with a little deflation if it stays a little,” says Marvin Goodfriend, professor of economics at Carnegie Mellon University in Pittsburgh. “The problem is, a little deflation will drag down inflation expectations. That’s what the Fed’s afraid of in a nutshell.”
With the Great Depression and Japan’s lost decade as its model, who wouldn’t be frightened?
In the Great Depression, the Fed allowed the money supply to contract by one-third. Currently, the broadest measure of the money supply, M2, is growing, albeit at a snail’s pace.
Japan as Model
Following the collapse of a stock market and real estate bubble in 1989, Japan failed to address its zombie banks. And Japan is “a bank-centric economy,” says Michael Bordo, professor of economics at Rutgers University in New Brunswick, New Jersey.
The Fed justifies targeting a positive rate of inflation to achieve price stability on the grounds that the CPI and PCE price index overstate inflation. That’s what they tell us. I’m not so sure. Neither is Goodfriend.
“To avoid raising prices, firms have made use of modern administrative technology to offload price increases to the customer,” he says.
That’s another way of saying that the art of buying something or following up on a service may entail navigating endless automated phone menus. The degradation of some services -- air travel comes to mind -- is completely subjective and therefore can’t be captured by the BLS’s quality-adjustment process. That doesn’t mean it’s costless to us.
At the Fed’s last meeting in April, the assessments of the risks to inflation were “mixed,” according to the minutes. Some members saw inflation risks as “tilted to the downside” because of excess slack in the economy. Others were concerned about rising inflation expectations, which have eased since then as commodity prices softened and Europe’s fiscal crisis punched another hole in the recovery story.
So much for Fed credibility. If financial markets had faith in the Fed to deliver price stability, inflation expectations wouldn’t ebb and flow from one day to the next in response to economic data or global events.
In the U.S., with housing struggling, bank credit declining and consumers still cautious, it’s far from clear the economy has reached a self-sustaining phase where it can comfortably be weaned from exceptionally low interest rates. If inflation expectations aren’t at zero, maybe the Fed needs to get more serious about price stability. And that would entail tolerating a little bit of deflation in the policy mix.
(Caroline Baum, author of “Just What I Said,” is a Bloomberg News columnist. The opinions expressed are her own.)
To contact the writer of this column: Caroline Baum in New York at firstname.lastname@example.org.