U.S.: That's Not Deflation Ahead, Just Slower Inflation
Prices are falling. Commodities are 12% cheaper than they were two months ago. Imports costs are dropping like a stone. Producer prices in October took the largest one-month dive on record. Sounds like it's time to worry about deflation, right?
Wrong. First of all, let's get straight what deflation is, and what it isn't. Deflation is a broad and lasting decline in the overall level of prices caused by a period of severely weak demand. Price drops in a few select goods, such as oil or computer equipment, is not deflation. Nor is it a slowdown in the growth of the price indexes. That's disinflation.
Instead, deflation works like inflation in reverse, a wage-price spiral that heads downward. Falling prices create expectations of further price declines, which cause people to delay making purchases. With demand weak, unemployment soars, causing wages to fall in tandem with prices. The real cost of borrowing rises, even as market interest rates fall to zero, so few companies want to borrow for new projects.
Think Japan. Prices for a broad array of assets, such as those for stocks and real estate, began to fall a decade ago. That led to a sharp contraction in economic activity that boosted unemployment to successive new highs in every year since 1998, and since then, wages have been falling. In September, they were down 3.5% from a year ago. Household spending has stagnated, forcing companies to cut prices further to bring in business. Consumer prices, down 0.8% from a year ago, have been falling since 1999. Even with market interest rates at zero, few in Japan want to borrow or invest.
IN THE U.S., nothing so pernicious is in the works right now. Nor will it be in 2002, because this year's aggressively stimulative policies will turn around demand before U.S. spending becomes so weak that wages begin to shrink across a broad swath of workers, as has occurred in Japan (chart). Consumer prices in the U.S. were up 2.6% over the 12 months ended in September, and wages have increased more than 4%.
To be sure, inflation is set to decline in the coming year, and wage growth will slow. That always happens in a recession. However, recent drops in the price indexes have more to do with transitory effects after the September 11 attacks and the ongoing strength in the dollar than with fears that demand is collapsing.
Indeed, retail sales rebounded with surprising strength in October. Incentive-driven car sales led the phenomenal 7.1% spending surge, but nonauto buying bounced back solidly as well. Excluding the 26.4% jump in car sales and the 6.4% drop in gasoline receipts caused by falling prices, retail sales recouped all of their September losses (chart).
As a result, consumer spending is shaping up to be much less of a drag on the economy in the fourth quarter than economists had expected, even if car sales fall back to more normal levels. The apparent mildness of the recession is the best argument against deflation.
SO WHY THE LATEST FLURRY of deflation stories? The media attention was triggered by recent price reports showing a drop in prices. First, the third-quarter gross domestic product data showed that prices paid by consumers for goods and services fell at a 0.4% annual rate from the second quarter. That was the largest quarterly drop in nearly five decades.
What went largely unnoticed, though, was that all of that drop occurred in September, when overall prices were dragged down from August by a sharp adjustment to insurance premiums after the September 11 tragedies. The Commerce Dept. subtracted the benefits paid out from premium expenses, making it appear as if consumers paid less for the same insurance coverage. The result was a record 1.4% drop in overall service prices from August to September. This measure of service prices has declined only once before in the postwar era, and the September falloff will not be repeated.
Then came the October producer price index, which plummeted 1.6%--also a record monthly decline. But, here again, all of the drop reflected blips that won't affect future months. The post-September 11 plunge in oil prices sent wholesale prices for gasoline and heating oil down more than 20%, and Detroit's sales incentives resulted in a 4.7% drop in car prices. Those two factors accounted for all of the month's plunge.
More important, the PPI covers mostly domestically made goods. Prices for those items are very sensitive to changes in global demand and to the price competition from cheap imports stemming from a strong dollar. As in 1998, when world demand sagged in the wake of the Asian crisis, the huge price drops in commodities and imports are fueling the deflation story (chart).
Also, bear in mind that goods prices don't tell you anything about the trend in service prices--58% of the overall consumer price index. Excluding the volatile ups and downs of energy and food, inflation for consumer goods has fallen to zero this autumn, but service inflation is running at more than 3.5%. Service inflation during the past year has been rising, not slowing, fueled mainly by faster growth in costs for health care and education.
CURRENT DEFLATION FEARS also ignore a crucial part of any price outlook: The link between wages and prices is just as important to deflation as it is to inflation. Wages must fall outright before deflation can truly be said to have taken hold of an economy.
Undoubtedly, wage growth will slow in the coming year as the unemployment rate rises. That's what happened following the 1990-91 recession. Back then, the jobless rate rose from just over 5% to almost 8%, and wage growth slowed from 4% to about 2.5%--a rate that prevailed for most of 1992 and 1993. But, again, pay didn't shrink, pay raises just got smaller.
A similar pattern is very likely to occur in 2002, as businesses strive for productivity gains in an effort to cut unit costs and restore profit margins. But since the jobless rate is unlikely to hit 8% next year, wage growth may not fall to as low as the 2.5% pace of the early 1990s. Moreover, 85% of the workers on private payrolls do not work in areas that produce domestically made goods. So the effect of today's falling goods prices on overall wages in the economy is too weak to breed broad deflationary conditions.
While deflation is an insidious disease, slowing inflation will be a plus for the economy. Right now, inflation as measured by the CPI is running at just over 2.5%. In 2002, the rate could easily fall into the 1%-2% range, leaving room for both profits and household buying power to grow, even in a sluggish economy. So put your deflation worries away. Instead, focus on the coming benefits of price stability, the holy grail sought by most central bankers and something the economy has not enjoyed since the 1960s.
By James C. Cooper & Kathleen Madigan