The Rising Threat of Deflation

July 26, 2010 03:57

The United States and Europe are heading toward–and Japan already suffers from–deflation, a classic prolonger of crises that boosts the real burden of debt and crushes profit margins.

By John H. Makin at AEI Online

As we enter the second half of 2010–the “postcrisis” year–while markets have been obsessed with Europe’s debt crisis, they have failed to notice potentially more ominous developments. The United States and Europe are heading toward–and Japan already suffers from–deflation, a classic prolonger of crises that boosts the real burden of debt and crushes profit margins.

U.S. year-over-year core inflation has dropped to 0.9 percent–its lowest level in forty-four years. The six-month annualized core consumer price index inflation level has dropped even closer to zero, at 0.4 percent. Europe’s year-over-year core inflation rate has fallen to 0.8 percent–the lowest level ever reported in the series that began in 1991. Heavily indebted Spain’s year-over-year core inflation rate is down to 0.1 percent. Ireland’s deflation rate is 2.7 percent. As commodity prices slip, inflation will become deflation globally in short order.

Meanwhile in Japan, while analysts were touting Japan’s first-quarter real growth rate of 5 percent, few bothered to notice that over the past year Japan’s gross domestic product (GDP) deflator had fallen 2.8 percent, reflecting an accelerating pace of deflation in a country where the price level has been falling every year since 2004. As of May, Japan’s year-over-year core deflation rate stood at 1.6 percent.

The Paradox of Crisis and Deflationary Pressure

The financial crisis of 2008 prompted aggressive monetary and fiscal easing by most governments. In the United States, the Federal Reserve cut its overnight lending rate to zero and tripled the size of its balance sheet during the year beginning in January 2009, during which time Congress and President Barack Obama enacted a substantial fiscal stimulus package.

Many market participants and policymakers have warned that such aggressive easing will lead to inflation. Contrary to those expectations, as noted above, core inflation has steadily moved lower in the United States and Europe and is approaching outright deflation, which Japan is already experiencing. By later this year, persistent excess capacity will probably create actual deflation in the United States and Europe. Moreover, the recent appreciation of the dollar, especially against the euro, exacerbates the U.S. deflation threat.

Fears of higher inflation are a persistent phenomenon at central banks after accommodative steps have been taken to cushion the negative impact on the real economy following a financial shock. During the Great Depression, the Federal Reserve allowed the money stock to fall rapidly because, among other concerns, Fed leaders feared inflation. The disastrous consequences, a serious exacerbation of the economic contraction already underway following the aftermath of a bursting bubble, are fully articulated in Milton Friedman and Anna Schwartz’s Monetary History of the United States, 1867-1960 (Princeton University Press, 1963).

More recently, the Bank of Japan, slow to ease after the real estate bubble burst in 1990, has pre-sided over two decades of disinflation that has become outright deflation. Japan’s nominal GDP, as of the first quarter of this year, at ¥480 trillion has dropped by an extraordinary 7 percent over the past two years because of a combination of outright deflation and low-to-negative growth. Perhaps even more dismaying, in 2010, Japan’s nominal GDP is equal to its 1993 GDP. It is encouraging to know that, after its May 20 meeting, the Bank of Japan’s policy statement expressed the need to be more accommodative in light of resumed signs of financial distress centered in Europe. Perhaps the Fed’s next policy statement after its June midyear policy review by the Federal Open Market Committee will emphasize further the need to remain accommodative for “an extended period.”

Why Crises Are Deflationary


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