4 Reasons To Fear Deflation

Falling prices can do much more damage than rising ones.

By + More

When the price of cars or sweaters or iPods declines, it's a break for consumers and a welcome sign that economic productivity is improving. That helps drive up living standards. But when the price of everything drops, it's an alarming development that portends stagnation.

The consumer price index, which measures inflation, declines every now and then, usually when there's a big drop in the price of volatile goods like energy or food. But there hasn't been sustained deflation in America since the early 1930s. Now, we may be on the verge of yet another unnerving economic adventure. Inflation over the last 12 months has been a scant 1.1 percent, which is below the level most economists deem optimal. And so far this year, inflation on a monthly basis has been negative as often as it's been positive. The odds are growing that low inflation could become deflation—with some economists worried that it has already started to happen.

[See 14 things that are getting cheaper.]

If you feel like cheering, don't. The Federal Reserve, with a mandate to keep inflation in check, prefers a "Goldilocks" economy, neither too hot nor too cold, with modest growth and an annual increase in prices of 1 to 3 percent. But inflation projections for the next couple of years are now coming in lower than that, and Fed policymakers have begun to hash out what to do if overall prices actually start falling. Here's why deflation can be such a thorny problem:

Once it arrives, deflation is hard to cure. Sustained deflation can become a pernicious problem that's hard to shake even when the government attacks it, as Japan has learned over a prolonged deflationary period that began in 1991. Falling prices cut into revenue at firms that build things and provide services, so they need to cut costs to remain profitable. That usually leads to layoffs and pay cuts. When people bring home less money, they invariably feel worse off and buy less. So demand for products falls further, forcing even deeper price cuts to entice consumers. Breaking the cycle becomes a destructive game of chicken between companies and consumers, with neither willing to take the first step.

[See why raises are so scarce.]

The mere fear of deflation can cause it. The level of confidence in the economy can be self-fulfilling, especially with deflation. If consumers believe that prices in general are falling, they'll wait as long as possible to buy stuff they don't immediately need, to get the lowest price. Falling demand then forces merchants to cut prices even more, to lure buyers. A good illustration is the struggling U.S. housing market, where falling prices have kept buyers on the sidelines as they wait for the market to bottom out—while lack of demand sends prices even lower. This is one reason why moderate inflation is considered healthy. If consumers believe overall prices are going up over time, they might wait for discounts or seasonal sales on some stuff, but they won't wait indefinitely to make ordinary purchases. Deflation, by contrast, can badly distort buying decisions.

Falling prices can be ruinous. Deflation also wreaks havoc with lending and credit, which is essential to a healthy economy. When prices and wages are falling, debts become more expensive over time, which is the opposite of what happens with normal inflation. If your income were falling by 3 percent a year, for example, and you made a fixed mortgage payment every month, then the mortgage payment would eat up an increasing amount of your income over time. Such perverse economics encourages savvy investors and ordinary consumers alike to hoard cash, since a 0 percent return on money stashed under the mattress is better than "investing" money in a home, business, or other asset that's likely to fall in value. Since credit is the lifeblood of capitalism, a sharp cutback in lending and investing is a sure way to torpedo growth or make a recession worse. That's what happened in Japan during its "lost decade," and even now, Japan still struggles with deflation and its nasty side effects.

[See 4 things financial reform won't do for you.]

Preventing deflation is tricky. The Fed has lots of experience at fighting inflation and fairly precise ideas for how to do it: Basically, raise short-term interest rates in order to raise the cost of borrowing, tamp down spending, and reduce the demand for goods, to help drive down prices. Doing the opposite to fight deflation works for a while, as lower rates make money cheap and boost the incentive to borrow and spend. The problem comes when the Fed's short-term rates get close to zero, which they are now. Since interest rates can't go below zero, this "zero-bound" problem forces the central bank to start pulling other, less-proven levers—like buying assets to inject money into the economy, which is essentially the same as printing money.

[See 6 strains on your financial future.]

The Fed has already executed some of those maneuvers, taking more aggressive action than bankers in Japan in the 1990s, who dawdled and made the problem worse. The Fed could do more if it seems necessary. The danger is that the Fed overshoots or guesses wrong, and ends up creating inflationary pressure that could force it to jack up rates down the road, which could choke off a recovery. At the moment, the Fed feels that deflation is possible but not likely, so it's sticking with policies geared toward low inflation. But the Fed has guessed wrong on the extent of unemployment and other issues, and its extended low-rate policy earlier this decade is widely viewed as a mistake that helped fuel the housing bubble. Let's hope the Fed has learned a thing or two.