The Danger This Time: Inflation May Be Too LowChristopher Farrell
Early this summer, the markets were roiled by an inflation scare. Gold was surging, a hoary reminder of rising prices to a generation seared by high inflation and double-digit interest rates in the 1970s. Federal Reserve Board Chairman Alan Greenspan talked of raising interest rates, and economists rushed to lift their inflation forecasts.
Today, gold prices have retreated, and yields on 30-year Treasury bonds have plunged to 6.17%. Inflation fears are subsiding. Says Allen Sinai, chief economist at Economic Advisors Inc., an affiliate of Lehman Brothers: "The widespread perception of a 3% to 3.5% inflation rate is wrong."
Possibly very wrong. During the past three months, producer prices fell at a 1.9% annual rate. Consumer prices rose at a mere 0.8% yearly pace, and many companies actually cut prices. Now, the danger is not that inflation is poised to break out soon but that certain prices could come down too far. If so, Greenspan, by threatening to tighten monetary policy, is sending the wrong message to business.
QUICK RETREAT. What's wrong with disinflation? Plenty, if it leads to deflation. "The inability to raise prices is causing businesses to cuts costs and trim payrolls," says Edward E. Yardeni, chief economist at C.J. Lawrence Inc. Workers, fearful of joining the ranks of the unemployed, turn cautious and spend less. Slack demand dampens growth. Lackluster activity keeps a lid on prices. Companies contract even more. In the end, slow growth and low inflation lead to more slow growth and low inflation.
John Maynard Keynes had it right 70 years ago. "The fact of falling prices injures entrepreneurs," he wrote in Social Consequences of Changes in the Value of Money. "Consequently, the fear of falling prices causes them to protect themselves by curtailing their operations."
The animal spirits of capitalism are certainly subdued, and signs of disinflation are everywhere. Procter & Gamble Co. has slashed prices on liquid detergents. Apple Computer Inc. has cut prices on computers by up to 35%. "I buy all the services and equipment for our company, and all I have to do is balk and vendors cut their prices," says Paul Getman, economist at Regional Financial Associates. All the evidence, from cutthroat global competition to retailing trends, suggests more downward pressure on prices. Oil prices are at their lowest point in three years. Inflation rates have been falling throughout the industrial world. In the six largest developed nations, high unemployment and ample capacity means further global disinflation and perhaps even outright deflation in 1994, says William Sterling, economist at Merrill Lynch & Co.
MISGUIDED. Consumers are certainly getting lower prices. Discounters account for 57% of department store sales, up from 47% five years ago. Tough competition from generic products is eroding prices on brand-name goods such as Pampers and Marlboros. "Consumer behavior is dampening inflation and, indeed, helps hold inflation in check," says Richard T. Curtin, of the University of Michigan.
If the underlying inflation is running closer to 1% than the 3% most economists assume, then interest rates are still high, after adjusting for inflation. That's partly why the economy has not responded better to low rates.
True, supply and demand imbalances will always send some prices skyrocketing. And no one wants a return to the vicious inflation of the 1970s. But in the midst of powerful disinflationary forces, the eagerness of Greenspan and his governors to raise interest rates at the first signs of faster growth is badly misguided. The danger is not that inflation in the 1990s will mirror the 1970s. It's that the economy won't get the stimulus it needs. The Fed is fighting the wrong war.