Was I Wrong to Be Worried About Deflation?

Last fall Dr. Oatley told me not to freak out about deflation as price indices fell despite the fact the Fed had dropped interest rates practically to zero. Since that time the Fed has engaged in unprecedented "quantitative easing" policies while keeping interest rates near the zero bound. Thankfully these actions, along with the bailouts and stimulus policies of the Bush and Obama Treasury Departments, have kept the American economy out of a deflationary spiral. The most recent data show a core CPI inflation rate (excluding energy and food prices) in the black.

So was I overreacting? I don't think so. For one thing it was not clear back in November that the Fed would engage in quantitative easing, or that those actions would have much traction. It also was not yet clear how long the credit crisis would persist, what actions the Treasury Department would take, or what effect a stimulus bill that was still months away would have. In fact, some of those questions are still unanswered.

But one thing is clear. The ECB and Bank of Japan adopted less drastic monetary and fiscal policies than the U.S., and the result has been record-setting falls in their price levels. They are still not in end-of-the-world territory yet (especially in Europe), but they are firmly in the danger zone. As Dr. Oatley wrote back in November, this is cause for concern for following reasons:

1. Debtors suffer as the real value of their debt rises. Hence, more difficulties to service loans (think about housing price collapses and mortgage foreclosures). Rising debt service problems can harm financial institutions (that's an ironic understatement).
2. Creditors benefit as the real value of their assets rises. Of course, this assumes that debtors continue to pay.
3. Consumers benefit, because things get cheaper every day.
4. Not so good at the aggregate level. If we expect everything to be cheaper next month, we won't buy it this month. If we all defer our purchases in expectation of lower prices in the future, our aggregate demand falls and we produce less--which means we employ fewer people. With less income from lower production, prices fall further, so we push our big purchases off to the future again. And so on and so on. Deflationary spiral, I believe it is called. This is pretty much what happened in 1929-1933.

And while arguing by anecdotes is logically fallacious, acknowledging them can be fun. So I observed with bemusement Emmanuel's suit-shopping adventure, in which he bought a Hugo Boss suit at a low rate. Looking sharp, Emmanuel, but couldn't you have gotten them to toss in a better tie?

Deflation Watch

Brad DeLong passes along a troubling picture:



Consumer prices were flat over the past 12 months.

Deflation Watch

Consumer prices grew 0.1% overall in 2008, but in the last quarter they dropped 0.7%. In 2007, the inflation rate was 4.1%. Over the last quarter, core CPI (excluding food and energy) fell at an annual rate of 0.3%.

Janet Yellon, President of the San Francisco Fed called these levels "unhealthy" and chided policymakers for not doing more to prevent the onset of deflation.

More here.

Treasuries Go Negative

Yesterday, 3-month T-bills traded slightly negative, while 4-week bills traded at 0.0% interest. In other words, investors were willing to accept a small negative return rather than risk larger losses elsewhere. This is good news for the government's balance sheet, but what does it mean for investors? A few things:

1. Confidence is exceptionally low.

2. Investors alluvasudden have a negative time preference for money.

3. Expectations about future inflation indicate that investors expect a dollar to be worth more in the future than it is today. In other words, bond markets expect deflation.

1 is definitely true, 2 is definitely false. i've been harping on 3 recently but even if it is true, why not just hold cash? Anybody got a better explanation? Is this being driven by large investment institutions who have to balance budget sheets and cash (for some reason) won't suffice? I'm really at a loss.

Another Data Point

Blue line: yield on 5-year nominal Treasury bonds

Red line: yield on 5-year inflation-adjusted Treasury bonds

The gap means that markets expect deflation in the short-to-medium run.

(ht: Mankiw)

Am I Freaked Out?

No I'm not. But I'm not happy. Here's a partial list of why:

1. We haven't had sustained deflation yet, but the fact that Core CPI -- excluding food and energy -- dropped by 1% in October rings alarm bells. But that's not the only data point [pdf]: the PPI (Producer Price Index) for finished goods dropped by 2.8% in October following smaller declines in August and September. Yes, that is seasonally adjusted. That is not the core figure (which is still positive) but firms in the energy and commodity sectors still employ people. To some extent CPI usually lags PPI, so it doesn't seem unreasonable to expect future drops in CPI as well.

2. Dr. Oatley advocates thanking the Lord for creating Keynes. I'll do that right after I'm done asking for my unicorn, but I'm a bit more pessimistic regarding the potential gains. As I see it, a drop in aggregate demand isn't the cause of this crisis: the credit crunch is. I can tell a story in which we issue a massive fiscal stimulus package, but citizens don't respond by boosting consumption. Instead they hoard it, anticipating deflation, or mounting unemployment, or foreclosure, or whatever else. Since this is going to be deficit-spending at a time when the government is already massively imbalanced, people should also expect future tax increases, which would also incentivize them to save it. And since credit is still locked up, there's no mechanism for steering those savings towards the businesses who need it. If they don't get cash, those businesses don't expand, unemployment mounts, deflation deepens, and we're spiraling.

There's actually some evidence for my story: Shapiro and Slemrod found that only 20% of people said they would spend their stimulus checks (in 2001 and 2008); the other 80% said they'd use them to pay down debt or boost savings. It's true that people don't always act as they say they will, but in this case Johnson, Parker, and Souleles found that they did (in 2001): each dollar of stimulus spending by the government resulted in roughly 33 cents of increased spending by consumers. Souleles also noted that that number might decrease in the present because the overall balance sheets of American consumers is worse off now than in the past because of declining home values.

I'm not saying it's not worth trying. All I'm saying is that if we can't unfreeze credit markets, it's probably all for naught.

Word of the Week: Deflation

Before Will gets us all freaked out about deflation, we should consider what is it, whether we are in it, and whether we should we care?

What is it: a sustained decrease in the general price level.
Are We in it:
Exhibit 1: The CPI fell by 1 percent in October relative to September. This is the largest decline since February 1947. Wow, that sounds scary.
Exhibit 2: Energy prices fell by 8%; transportation prices (cars) fell by 5.4%; clothes prices fell by 1%. Other prices rose slightly. This is neither general nor sustained.

On balance, no, we are not in deflation. We are seeing relative price changes; energy prices are down (that's good news) and the auto industry just had about its worst month ever.
Yet, we are at the risk of falling into deflation.

Should We Care? Yes
1. Debtors suffer as the real value of their debt rises. Hence, more difficulties to service loans (think about housing price collapses and mortgage foreclosures). Rising debt service problems can harm financial institutions (that's an ironic understatement).
2. Creditors benefit as the real value of their assets rises. Of course, this assumes that debtors continue to pay.
3. Consumers benefit, because things get cheaper every day.
4. Not so good at the aggregate level. If we expect everything to be cheaper next month, we won't buy it this month. If we all defer our purchases in expectation of lower prices in the future, we aggregate demand falls and we produce less--which means we employ fewer people. With less income from lower production, prices fall further, so we push our big purchases off to the future again. And so on and so on. Deflationary spiral, I believe it is called. This is pretty much what happened in 1929-1933.

So yes, we should care. Will's point, I think, is that monetary policy is increasingly of little utility because nominal interest rates are close to zero. I might point out to Will that the good Lord had the sense to create Sir JM Keynes in order to alert us to the utility of fiscal policy in precisely this circumstance.