For years, a number of economists have been warning that deflation was the economy's most serious problem. Deflation is negative inflation, or falling rather than rising prices. Of course, some prices are always falling, even during periods of inflation. The term deflation, therefore, refers to a simultaneous fall in a broad range of prices for many goods and services.
The economists warning about deflation argued that certain prices tend to lead the general price level up or down. These include gold, the exchange value of the dollar and prices of long-term Treasury securities, among others. The reason is that speculators, who sense that inflationary or deflationary conditions may be arising, will attempt to profit from this knowledge by buying commodities or assets that tend to rise especially fast during inflations and selling them short during deflations. Someone who sells "short" benefits from falling prices because he sells first and then buys later, presumably at a lower price.
When one sees a sustained fall in sensitive commodity prices -- those that lead changes in the general price level -- one can predict that eventually this trend will work its way through the economy as a whole. The lag, however, can be long because prices for most things that people buy change only very slowly. Thus our measures of general price changes, such as the Consumer Price Index, are really backward-looking.
Now we are starting to see deflation showing up in price indexes. The CPI fell 0.3 percent in October, and the Producer Price Index dropped a huge 1.6 percent. Economists and journalists who had previously pooh-poohed the idea of deflation suddenly took notice. For example, on Nov. 2, Floyd Norris of The New York Times wrote an article titled, "For the First Time Since Ike, a Whiff of U.S. Deflation." A Nov. 12 Wall Street Journal report was headlined, "Falling Wholesale Prices Give Whiff of Deflation."
This has led to a counterattack by some economists, who maintain that inflation is the true economic problem. Milton Friedman has warned that increases in the money supply that have already occurred may lead to inflation next year. Craig Thomas of Dismal.com says he would strike the word "deflation" from the dictionary if he could. Lew Rockwell of the Mises Institute said that even if there is deflation, which he doubts, it is a good thing. Lower prices just mean that he can buy the things he wants for less.
To be sure, small, isolated episodes of deflation are nothing to be concerned with. Indeed, they are an unavoidable consequence of achieving price stability. It is impossible to have zero inflation month after month even under the most stable price regime. But prices will tend to fluctuate around zero over time, with brief periods of inflation offset by equal and opposite deflations. That may be all we are experiencing.
However, those who have been warning about deflation for some time, such as Jude Wanniski of Polyconomics.com, say that because sensitive prices have yet to turn up, the recent declines in the CPI and PPI will continue for some time, as past deflationary forces work their way through the economy. These forces are fundamentally monetary in nature and thus the result of a tight Federal Reserve policy.
Therefore, it is still possible that the worst of the deflation is yet to come. If this is the case, the economy may fall further before it rebounds. That is because deflation raises real interest rates. Since the real rate equals the market rate minus the change in prices, deflation adds to the market rate. Thus, if prices are falling 5 percent per year and the nominal interest rate is a modest 3 percent, then the real interest rate is actually a high 8 percent.
Sustained deflations also raise real wages for the same reason. Higher real wages force layoffs as employers try to economize on labor costs. And deflation rewards creditors and those with cash at the expense of debtors and those with illiquid assets. For these reasons, most economists believe that a sustained deflation is far more damaging to the economy than an equivalent inflation. Indeed, a recent study from the Milken Institute argues that economic growth is maximized at an inflation rate of between 1.6 percent and 3 percent per year.
The outcome of this debate is important not just for economic forecasting, but because the Federal Reserve is very much influenced by the conventional wisdom among economists. When the Fed meets again on Dec. 11, the topic of deflation will undoubtedly be on the agenda for discussion.