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Deflation Boogeyman (Robert J. Samuelson, May 14, 2003, The Washington Post)

Inflation looks defeated. In March the consumer price index was up 3 percent from a year earlier; that's unimpressive, but much of the increase stemmed from soaring oil prices that are now receding. What's called "core inflation," without erratic energy and food prices, is rising at about a 1 percent annual rate. Moreover, prices for many expensive items have been dropping for several years. Since March 2000, prices have declined 2.8 percent for cars, 3.4 percent for major appliances (including washers, dryers and microwave ovens), 9.9 percent for women's suits and 57 percent for personal computers.

These price decreases reflect new technology, better management and intense competition, including imports. But a few falling prices don't make deflation if -- as is now true -- other prices are rising faster. Since March 2000, prices are up 19.5 percent for college tuition, 16 percent for nursing-home care, 10.5 percent for car repair and 8.8 percent for haircuts. It's often said that deflation can't happen because services (about 60 percent of the consumer price index, covering everything from health care to housing) don't experience productivity gains and prices don't decline.

This argument is weaker than it sounds. Big price declines for goods (cars, computers, etc.) could overwhelm modest increases in services. And some services do benefit from productivity gains; prices for cellular phone services have declined 14.6 percent since March 2000. Elsewhere, other services (airfares, hotel rates) drop because they can't defy the law of supply and demand. And suppose deflation does occur? Why would that be bad? Lower prices would allow people to buy more with their wages; the economy could benefit.

But what's also true is that deflation poses dangers: (1) lower prices could squeeze corporate profits, hurt the stock market and pressure companies to fire workers and cut wages; (2) falling prices could lower overnight interest rates to near zero, making it harder for the Fed to stimulate the economy; (3) companies and farmers might default on loans, which are fixed while the prices they receive fall, and (4) consumers might delay purchases, believing future prices will be lower. In the Depression, the dangers materialized. From 1929 to 1933, retail prices dropped 24 percent. Thousands of businesses and farmers went bankrupt. About 40 percent of banks failed. By 1933 unemployment was 25 percent. Although the Fed cut interest rates, the economy didn't respond. (In the summer of 1931, the Fed's discount rate was 1.5 percent; but prices were down 9 percent, meaning that loans were repaid in more expensive dollars and that the true cost of money was almost 11 percent.) Still, deflation doesn't always spell disaster. From 1870 to 1896, prices fell about 1.2 percent a year, reports a study by economists Michael Bordo of Rutgers and Angela Redish of the University of British Columbia. Despite periodic slumps and banking crises, the economy grew about 4 percent annually. Income per person rose about 1.6 percent a year. Industrialization spread. From 1870 to 1890, iron and steel production quintupled, cigar production almost quadrupled and sugar production nearly tripled. Farmers' complaints about falling prices and oppressive debts triggered a populist backlash, but mainly workers and companies adapted.

A year ago the Fed published a study by its economists on Japan's deflation. The chief conclusions were that the Japanese hadn't anticipated deflation and that their countermeasures were too little too late. Once deflation becomes a possibility, the study said, a government should undertake economic stimulus "beyond the levels conventionally implied'' -- an ounce of prevention being worth a pound of cure. It may be that even lower interest rates and, temporarily, even bigger budget deficits are necessary. This is, as yet, a lesson that still makes Washington uncomfortable.

What should frighten people is that it has been obvious that the conditions for deflation were forming for several years now, and yet, with near universal approval, Mr. Greenspan and the Fed spent the last year (or more) of the Clinton administration raising interest rates to fight inflation. Meanwhile, Mr. Samuelson is the best economic columnist in America, but nothing in this column suggests that even he has a grip as yet on what's going on and most of his peers haven't even figured out this much yet.

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US Treasury yields hit 45-yr low, deflation eyed (Eric Burroughs, May 14, 2003, Reuters)

U.S. Treasuries rallied on Wednesday, driving benchmark yields to 45-year lows as weak retail sales and a record drop in import prices stoked expectations the Federal Reserve may soon cut interest rates to fight the threat of deflation.

Thirty-year bonds jumped nearly 2 full points on the session, pushing their yields to all-time lows as bond investors anticipated that the Fed, with little room left to keep cutting rates, may have to take up extreme policy weapons like buying Treasuries.

"If we get a run of weak data, you will hear a lot more chatter about unconventional Fed action," said Michael Cloherty, fixed-income strategist at Credit Suisse First Boston. "The odds are still very low, but it's moved into the conceivable."

Posted by Orrin Judd at May 14, 2003 7:07 PM