Are we headed for deflation? | Notes from Jim Haughey

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Notes from Jim Haughey
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Are we headed for deflation?

Jim Haughey

RCD Chief Economist

Dec 19, 2008

The Consumer Price Index (CPI) had dropped 2.8% since July, a -8.1% annualized rate. The Producer Price Index (PPI) has dropped 6.1% since July, a -18.3% annualized rate. While these are unusually large declines, they are almost entirely in energy and metal products with a minimal spillover to other items. The core CPI – excluding food and energy – has stopped rising and fell 0.1% in November. The core PPI is still rising.

As the recession deepens more price cuts will appear that were not driven by lower commodity prices but by reduced seller margins and surplus inventory distress sales. It is likely that price indexes will fall modestly through the winter. But if falling prices end then, the August-March period will be an episode of adjusting to lower prices and not deflation.

Whatever the price trend beyond March, the economic data reports in current dollars have to be interpreted with the current inflation trend. Otherwise the news will be interpreted as worse than it is. For example, November retail sales were reported in scare headlines to be down 1.8% from October. But the CPI fell 1.7%. Most of the retail sales decline was a reduction in the price of gasoline. Otherwise, sales in every major retail category was steady to slightly higher.

The Census Bureau Report of November construction spending, to be released in early January, will likely show an outsized decline. Spending declined 1.2% in October. Note that the construction price index dropped 3.2% in November. This overwhelms the trend 0.2-0.3% monthly rise in labor and overhead costs so total project cost dropped in November. This contrast with monthly project cost increases as high as 0.7% earlier in 2008.

Similarly, the transition to declining prices provides the illusion that the recent declines in nominal interest rates, both mortgages and business loans, means a move to cheaper credit. Not so. The drop in the inflation rate has been larger than the 100-150 basis points decline in nominal interest rates. Credit has become more expensive in a period of de-leveraging and reduction in lendable funds.

The risk that the ongoing fall in prices will become a sustained period of deflation is still small. Nonetheless, all of the preconditions are now here: a recessionary economy, a period of falling prices and policy interest rates at 0.0% so no further cuts to stimulate spending and re-inflation are possible.

This was the situation in Japan in the early 1990’s which did lead to an extended period of deflation which further depressed the economy as both consumers and business deferred purchases, waiting for lower prices. Fortunately, the FRB has learned from Japans’ mistakes. Japan stubbornly refused to force its major lenders to recognize their losses and recapitalize after the bursting of their real estate and stock market bubbles created a need to de-leverage and reduce credit. The Japanese efforts to avoid a short, sharp recession got them many years of near 0.0% economic growth.

Ominously, some of the leaks from the Obama transition team suggest an inclination to stop the recession at any cost, even if this means propping up failed enterprises and households so that they are a drag on economic growth for many years. Deflation and a stagnant economy has become a much larger risk in the last few months.