Earlier this month, the Federal Reserve - America’s central bank - announced that it may cut interest rates again this year in order to stave off the danger of deflation.
“Deflation is a time when prices on average are declining,” says Gary Shilling, an economic consultant and investment advisor from New Jersey and the author of two books on deflation.
“When you have more supply than demand, then prices decline in order to induce people to buy because there’s simply too much of everything,” he says.
In the short run, low prices may be good for consumers. They can buy more with their wages. And that could be good for the economy. But prices that continue declining over an extended period, reduce profits for merchants and businessmen. To cut their losses, they may decide to lay off some of their employees, which in turn can increase unemployment rates. Falling prices also make it harder to repay debt, trigger a drop in the value of assets, such as homes and stocks, and make it more difficult for a central bank to stimulate a lagging economy.
In April, U.S. consumer prices registered the biggest drop in the past 19 months: .03%. Wholesale prices fell a record 1.9%. According to the U.S. Department of Labor, the drop was mostly due to energy prices, which plummeted for the first time since December. Gasoline prices went down 8.3%, the biggest decline since November 2001. Transportation, housing, food and car prices also declined last month, although by less than 1%.
Prices for many expensive items have been declining for several years. Since March 2000, they were down 2.8% for cars, 3.4% for major appliances such as washers, dryers and microwave ovens, and more than 50% for personal computers.
So is America in deflation? “If we are not in it, we are awfully close,” says Mr. Shilling. For the past 50 years, American economists have worried about inflation. The last time the country suffered from deflation was during the disastrous Great Depression of the 1930’s. Many analysts say the current decline in prices of consumer goods does not translate into general deflation. Richard Yamorone, chief economist of Argus Research Corporation in New York, points out that prices of services have been rising.
“The Federal Reserve, who keeps claiming that there is deflation out there, or maybe concern of deflation, is looking at the goods’ prices and seeing them fall rather than looking at the services’ prices, which are not really measured properly and they have been rising,” he says. “The medical costs, pharmaceutical costs, drugs, rent, tuition legal expenses - those things are rising and some of those things are very, very necessary.”
Americans are paying more for college tuition, insurance, health care, entertainment and various services, from car repair to haircuts. For example, the average cost of college tuition and fees at a four-year private college rose by 5.6% annually over the past three years. A survey by the Kaiser Family Foundation shows that the average monthly cost for family health insurance coverage is up 8% a year from 2000 to 2002. So, says Richard Yamorone, while the United States has suffered from slow economic growth, there is no danger of deflation.
William Niskanen, chairman of the Cato Institute, a research organization in Washington D.C., agrees. “Any number of industries will face a deflationary situation, but the overall price level, I think, will still be increasing at a one to two percent annual rate,” he says.
Mr. Niskanen says prices of consumer goods are declining for several reasons. One is increased productivity due to advanced technology and better management. Intense competition -- including imports -- is another factor. In some areas prices have declined because of a drop in demand. For example, says Mr. Niskanen, travel and hotel industries are going to suffer because of the fear of terrorism and spread of SARS. But the Cato analyst thinks there is no more reason to fear deflation than to fear inflation.
“Inflation helps debtors because it reduces the real value of the debt that they owe,” Mr. Niskanen says. “Deflation helps lenders because it increases their real claim on resources from the debt that is owed to them. So there is some redistribution of income that is a consequence of both: inflation or deflation. But when the relative magnitudes of these phenomena are small, I think this is not a matter for general concern.”
Still, some economists recommend that in the present situation Americans should keep a tighter rein on their debts. Gary Shilling warns that in a deflationary situation, it may be extremely hard to repay debts.
“So I would suggest that people repay their debts, that they work down credit card balances, pay off mortgages, reduce auto loans, try to get themselves in much better shape financially than they have been for decades,” he says. “Because inflation was a great friend of the big borrower, but deflation is the enemy of borrowers.” Statistics show that many Americans are working on reducing their debts. One indicator is the growing use of debit cards instead of credit cards for shopping. Debit cards allow buyers to spend only the money they have in the bank, as opposed to credit cards, which allow them to borrow money they do not have. Economist Gary Shilling says this trend may hurt countries that depend on exports to the United States.
“People (in the United States) have been big buyers. And of course, that’s very important to the world. That’s why we have this huge trade deficit of about $500 billion a year. And we are basically buying goods and services of the rest of the world that they in all likelihood could not sell anyplace else,” he says.
“We are the buyer of the first and last resort. If we are right that consumers are starting to retrench -- and this is a long-term phenomenon -- that plus the other deflationary effects will be very difficult for the rest of the world. Because we’ll see our trade balance shrink -- not because the rest of the world is buying more of our goods, but because we are buying less of their goods and services,” says Mr. Shilling.
The Cato Institute’s William Niskanen says if the U.S. trade deficit does shrink, it will be because the value of the dollar has declined, especially in relation to the Euro - not because of deflation.
“When foreign goods and services are higher price in dollars, that will help reduce the amount that we import,” he says. “And American goods and services then will be a lower price in Euros and that will increase our export somewhat. So the change in the exchange rate, in this case between the dollars and Euros, will help correct or discipline the amount of the trade deficit by reducing the price of American goods abroad and increasing the price of foreign goods in the United States.”
A year ago, the Federal Reserve published a study by its economists on deflation in Japan. The chief conclusion was that the Japanese hadn’t anticipated deflation and therefore their countermeasures were too weak and too late.
Once deflation becomes a possibility, the study said, a government should undertake strong economic stimulus to prevent it, such as lower interest rates and bigger budget deficits. American economists disagree on the seriousness of the deflation threat, but they are considering the possibility and are discussing ways of averting it.