Deflation Threat Is Real As Inflation Begins to Fall

Amid a progressively weaker economy and the financial crisis, the threat of deflation becomes a concern as inflation begins to fall. Deflation is caused by a sustained drop in overall demand and falling prices that forces businesses to cut prices ever deeper. It was last seen in the U.S. in the 1930s and in Japan in the 1990s, when the inflation rate fell to zero and then turned negative for several years.

The most recent figures show all of the factors that fueled earlier inflation worries have sharply reversed course.

Consumers are retrenching their spending at a 3.1 percent pace, the first decline in 17 years and the sharpest quarterly drop since the second quarter of 1980. Consumer confidence hit an all-time low of 38 in October, the lowest reading ever recorded since the survey began in 1967.

Job and wage growth are weakening at faster rates. Unemployment is expected to rise from its current level of 6.1 percent.

The stronger dollar is pushing down import prices as well as crude-oil and other commodities prices. The 15-nation Euro last week fell to its lowest level against the dollar since April 2006 while the pound at one point last week lost a staggering 8 cents against the dollar, the biggest intraday move since exchange rates became freely floated in 1971.

Oil prices have plunged spooked by the dim outlook for the U.S. economy. Oil fell 33 percent in October, a record monthly decline, settled at $67.81 a barrel at 2:52 p.m. on the New York Mercantile Exchange. Oil has fallen by 54 percent since reaching a record $147.27 on July 11 and now is down 28 percent from a year ago. Cheaper oil will magnify the coming slide in overall inflation.

Even excluding oil, commodity prices have collapsed. The Reuters/Jefferies CRB Index of 19 raw materials plunged to 256 on Oct. 24, the lowest since Sept. 8, 2004. The gauge had lost more than 40 percent since reaching a record at 473.52 on July 2 as the credit crunch choked worldwide growth.


Asset-price deflation is especially corrosive. The Dow Jones industrial average fell to 9,325.01, or 14.1 percent in Oct, the worst month for the blue-chip benchmark since August 1998. The Dow has fallen 34 percent since its last peak in Oct 2007. The broader stock index S&P 500 dropped to 968.74, or 16.8 percent in Oct, worst month record in 21 years. Since its last highest close in Oct 2007, the S&P has plunged 38 percent.

The Standard & Poor's Case-Shiller Home Price index is down 20 percent.

Asset-price declines are part of a broad deleveraging by financial firms and households. This forced reduction of debt is fueling the sale of homes, stocks, and other securities at heavily discounted prices. The process has been shutting off new lending in a self-reinforcing spiral that destroys wealth and depresses demand. The destruction of this deleveraging process makes this business cycle even more susceptible to deflation.

Yearly consumer inflation peaked at 5.5 percent in July but is set to fall to close to zero by early next year. Still, prices outside energy and food will determine whether broader inflation may be falling too rapidly.

Deflation is burdensome for borrowers. As prices are falling, borrowers have to pay back loans in dollars that will buy more goods than the dollars when they borrowed. Deflation also raises the real, or inflation-adjusted, cost of borrowing because policy makers cannot cut the target rate below zero. At that point, negative inflation is counterproductive as it keeps the real rate high enough that restrict efforts to boost spending and economic growth.