The U.S. Welcomes the Good Kind of Deflation

The U.S. is enjoying a bit of good deflation mostly because advances in shale oil production have flooded the market with cheap oil.

Photographer: Daniel Acker/Bloomberg

For the U.S. economy, the deflation that’s seizing Europe sounds like the rumble of distant thunder. The low-pressure system probably won’t swirl across the Atlantic, but the risk of deflation in the U.S. can’t be completely dismissed.

As the world’s biggest economy, the U.S. is more insulated than European nations, making it better equipped to withstand troubles abroad. U.S. gross domestic product is likely to grow 3.2 percent this year, up from an estimated 2.4 percent in 2014, according to the median estimate of economists surveyed by Bloomberg. Job growth is running at almost 250,000 a month, creating a virtuous circle: When people get hired they spend more, putting money into the coffers of companies that go out and increase their staffing.

There are two kinds of deflation. The good kind occurs when prices fall because efficiency and technology lower the cost of products and services. The bad kind occurs when unemployment is high and a lack of demand forces companies to cut prices.

The U.S. is enjoying a bit of the good deflation. The U.S. consumer price index fell 0.4 percent in December, but it was mostly because advances in shale oil production have flooded the market with cheap oil. A shortfall in demand for oil overseas has also contributed. “With the big drop in gasoline and other energy prices, workers’ paychecks are going farther, allowing them to boost their spending on other goods and services,” Gus Faucher, senior economist at PNC Financial Services Group, wrote in a Jan. 16 report. The University of Michigan’s preliminary measure of consumer sentiment rose in January to its highest level in 11 years.

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Europe is fighting the bad kind of deflation. To spur growth, the European Central Bank is trying to push down long-term interest rates. On Jan. 22 the ECB was expected to announce a massive bond-buying program. Global investors are abandoning euro zone states, with their poor growth prospects and unattractive interest rates, and pouring money into the U.S. The dollar is up 14 percent against a basket of other currencies since last July, according to the Bloomberg Dollar Spot Index.

The dollar’s rise vs. the euro makes European goods and services cheap in the U.S. and American goods and services expensive in Europe. That will put a dent in U.S. employment growth this year, though how large a dent is hard to say. In effect, Europe is exporting part of its deflation and unemployment problem to the U.S. Switzerland will be harmed far more than the U.S.; its economy is more tightly coupled with that of the euro area. On Jan. 15 the Swiss National Bank gave up on keeping the value of the Swiss franc at a low level against the euro: The currency leapt 20 percent vs. the euro in response.

Is Europe instigating a currency war, trying to depreciate its way to growth by beggaring its neighbors? Not exactly. The ECB is using low interest rates to encourage borrowing, drive up stock prices, and promote domestic growth, as is the Bank of Japan. In both cases, central bankers argue that currency depreciation is a side effect, not the objective. Other countries are free to do their own monetary stimulus, which would tend to prevent the euro from depreciating vs. their currencies. A group of deflation-ridden countries that adapted loose monetary policies could all end up better off even if there were no change in the relative value of their currencies. No one would gain an export edge, but the easy money would stimulate domestic growth.

The risk for the U.S. is that the dollar could get even stronger if the rest of the world is easing monetary policy. Although deflation isn’t on the horizon in the U.S., neither is inflation. In December the core consumer price index, which excludes food and energy, was unchanged compared with November as prices of apparel, vehicles, and airfares fell. Inflation well below the Fed’s 2 percent target will make it harder for the hawks on the Federal Reserve’s rate-setting committee to justify hiking interest rates this year. The U.S. economics team at Bank of America Merrill Lynch, in a client note, said it well: “Our expectation is that the policy debate is heating up as inflation cools off.”

The bottom line: The U.S. has so far kept deflation from stifling the economy: GDP is expected to grow 3.2 percent in 2015.

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