|
Economic News & Analysis - July 20, 2010
Who's Afraid of Deflation?
By Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist
No one’s excited about the Bureau of Labor Statistics report, which stated that “median weekly earnings of the nation’s 99.8 million full-time wage and salary workers were $740 in the second quarter of 2010 (not seasonally adjusted). This was 0.8 percent higher than a year earlier,” the report continues, “compared with a gain of 1.8 percent in the Consumer Price Index for All Urban Consumers (CPI-U) over the same period.” Nominal wages were higher, but inflation – though low – was also higher, meaning that real wages fell. In exchange for a week’s work, less could be purchased this year than last year. (Of course, the workweek was also about 0.89% longer in 2010 than in 2009.) With inflation, disinflation, or deflation, real purchasing power goes down – and that hurts.
One of the things I have heard recently is that deflation is more dangerous than inflation. There are typically two reasons given for the hazards of deflation: (1) in a deflationary environment, asset prices go down, which destroys wealth, and (2) there is nothing the Federal Reserve can do to combat this trend. Both of these reasons, I think, are flawed; although I also believe the first reason is more credible than the second.
The Debt-Deflation Spiral
Deflation describes a condition of general decline in the prices of goods and services. Asset prices are not part of the measure of “the price level” – at least not according to the classical definition. In fact, asset prices don’t necessarily go down when there is deflation. And whether or not they do go down depends on a large number of factors.
One major factor is the reason for deflation. If it’s caused by technological advances, it is generally viewed as a good thing. Think of computers. You can purchase the same processing capability today much more cheaply than you could five years ago. This type of deflation signifies that we can now produce more with less, and we are richer than we once were.
But deflation that’s caused by declining economic activity can be a problem. Not only does this type of deflation reflect a general economic malaise, it can also cause economic distortions, as all prices do not move up and down in tandem. Some of these distortions can be painful, for example, if your wages fall more than the price of goods and services you buy.
These examples show that, while deflation in and of itself is not a problem, it becomes one when it causes a decline in people’s standards of living or causes a misallocation of resources. Personally, I don’t think we have, or will have (at least within the next year), a general deflation. I do think we’ll have a continuation of what we’ve already seen: some months of inflation, some months of deflation, and changes in relative prices. Food and energy prices may continue to come down while other prices inch higher. That’s not inflation or deflation. It’s both.
Deflation isn’t necessarily a problem if you expect it. But the mortgage you took out when you were thinking inflation would average 3% over the life of the loan suddenly looks more expensive when inflation actually comes in lower than that. In fact, the real cost of that debt has gone up. Assuming you don’t default, a real transfer of wealth in this case issues from the borrower to the lender. Another way of looking at it is that an unanticipated decline in the rate of inflation results in a transfer of wealth from debtors to savers. Savers aren’t hurt unless the debtors don’t pay their loans back. This can lead to what is sometimes called a “debt-deflation spiral,” where debtors default and the assets are sold at fire-sale prices, which lowers prices, which makes other debt more burdensome, which causes a further decline in asset prices, and so on. This type of cycle never ends well.
Monetary Policy Can Always Get Looser
As for the second reason to not like deflation – the Federal Reserve can’t do anything about it – I’m much more skeptical. With interest rates at near zero, some people say our interest rate is “zero-bound.” As anyone with a checking account knows, interest rates – even nominal interest rates – can go negative. That’s called a “fee.”
The Federal Reserve has the power to pay interest on bank reserves. Nowhere is it written that interest rates can’t be negative. If the Fed wanted to loosen monetary policy even more, it could simply assess a fee against banks that hold excess reserves. Instead of paying 0.25% on excess reserves, the Fed could pay 0%, or even -0.25%. I don’t think they will, but the point is that monetary policy can always get looser.
Another possibility is that the Federal Reserve could do what Fannie Mae and Freddie Mac did. The Fed could become “Feddie” by engaging in even more of what it calls “quantitative easing.” The Federal Reserve changed the size of its balance sheet by buying up all sorts of mortgage-backed securities. In exchange, the Fed created bank reserves. Isn’t that basically what Fannie Mae and Freddie Mac did when they bought packages of mortgages and issued their own securities? The Fed could go out and buy corporate bonds, stocks, houses, cars, or anything else if it really wanted to expand its balance sheet. The problem – besides having the Fed being engaged in the allocation of credit and not just the availability of credit – is that maybe some of those assets shouldn’t be bought. That’s the basic argument surrounding the activities of Fannie Mae and Freddie Mac: they created an environment in which loans were made that never should have been made to begin with. Who says the Fed will do a better job of allocating credit?
I’m not afraid of deflation. What I am afraid of is what policymakers might do to try to combat it. Let’s face it – the federal debt is really big and the federal government (that is, the taxpayers) has a lot to lose if the real burden of that debt goes up. Maybe deflation isn’t the problem. Maybe the problem is too much debt.
|
