Deflation as a Symptom: Leading Indicators Down
Few economic events stir up fear faster than deflation. In a technical sense, deflation is merely the opposite of inflation; overall prices drop rather than rise. It doesn’t mean that all prices drop, but the average of all prices will drop during deflation.
The fear factor that deflation brings is because it is associated with bad economic times rather than good times. The NY Times graph below does a good job of showing this association. Note that in the shaded areas, areas when the economy is in recession, is also the time, for the most part, when price deflation occurs. There are brief periods where year over year prices may fall for a short time without being in recession, but in all cases where falling prices lasted for a long time, a recession or depression was in
process.
The economics behind this phenomenon are simple: falling prices discourage spending, since a consumer will reasonably conclude that a by waiting to buy, a better price could be had. If you are contemplating buying a new car, for example, wouldn’t it be wise to wait until prices fell? Any good or service that is not needed immediately, then, can be postponed. When most everyone in the economy reaches the same conclusion, then you begin a price spiral downward that makes the already bad economy much worse. Manufacturers have to cut prices further trying to stimulate sales of existing inventories, which is also usually accompanied by further cuts in production and cuts in the number of people on the payroll. A downward spiral is, indeed, a fearful state of affairs for an economy, and it proved to be difficult to break out of in the Great Depression of the 1930s.
The good news is that WWII taught us the secret of defeating deflation. Now, it is seen as comparatively easy to break deflation by simply printing more money or by the Federal Reserve System buying bonds. More money in circulation will force prices up, so monetary policy and fiscal policy can work to put more money into circulation and more income to spend.
A countervailing fiscal policy has characterized economic policy of all the developed nations since WWII. Monetary policy has been used to control prices, especially after the contribution of Milton Friedman in the 1970. Using the two tools, monetary policy to keep price inflation and deflation under control and fiscal policy to keep aggregate demand healthy, there have been fewer recessions and more moderate price crises in decades after WWII. Notice in the chart above the length between recessions from earlier in the Century.
We are undoubtedly in a period of deflation for now, but actual price declines have been measured for only a couple of months. Deflation would become a serious problem only if the price decline persists for a long time. I doubt that the Federal Reserve would permit this, since their Chairman is a scholar on the Great Depression and is fully aware of the danger its poses.
Many economists are predicting an end to the recession at some point after mid 2009. Some see a recovery later, even as late as the last quarter of next year. What we are experiencing is without question a serious downturn, and there is little about it that we can like. All we can do is to enjoy the drop in prices while it lasts, because it won’t last, if my reading of the economy is correct.
Leading indicators, a compilation of 10 individual statistics that point to the next three to six months, was bad for November. Published by the Conference Board in New York, the chart below has the details.
The index has decreased 2.8 percent in the six months through November, the worst drop since 1991, when the economy was in a recession.
Drops in building permits and share prices, and increases in unemployment claims, led the index lower.
