Inflation - Deflation?

There are still many who predict the United States and its citizens are doomed to undergo a major depression because of the tremendous debt and the Government intervention in the free market system. Dire predictions like these have been made many times before but in times of severe economic contraction they get a lot more attention.


There are competing doom scenarios, one that predicts severe inflation and one that predicts severe deflation. Now both end up with quite dire forecasts and it sort of reminds me of a Robert Frost poem Fire and Ice.

We have been experiencing deflation recently, although it is not fully represented in the CPI. The June CPI shows an overall decrease of -1.4 year over year. A lot of this reduction is due to the change in oil prices and it would have been much worse if the Medical and Services areas didn't continue to have price increases. The oil prices from last year are clearly a short term phenomena and do distort the index. However, I think most of us feel that whatever the official statistics show, the actual cost paid for many things is significantly less than it was one or two years ago. Consumer spending is down significantly and with less demand, the price curve goes down.

Now in order to combat weak demand and potential deflation, the Fed has lowered interest rates and the Government has increased deficit spending. This takes us to the inflation scenario, one in which proponents of monetary theory believe the increase in money supply can take us no where else.

It does seem that considering supply and demand, an increase in the money supply without a corresponding increase in demand will lead to a lower price for the dollar and therefore inflation. Of course this assumes the real money supply has increased, which may be debatable considering the higher reserves held at banks and loss of wealth (i.e. money) due to the drop in housing and equities.

So would either deflation or inflation be disastrous? Depends on ones definition of disaster.

Concerning deflation, one can look at Japan which has been in a deflationary period since the mid 1990s. There was some belief that it was starting to emerge from it, but recent events call that into question. The main problem with deflation is that economic activity slows, borrowing becomes difficult as debt becomes more expensive over time and economies tend to stagnate. However, looking at Japan over the period of deflation, does not indicate that society as a whole collapsed, and the standard of living for most Japanese had been maintained at respectable levels.

As far as inflation goes, there are a number of examples of ruinous inflation, perhaps most notably the Wiemar republic. Inflation there completely devalued the Mark, led to the fall of democracy, the rise of Nazism and ultimately World War 2. Now, other countries have also had sever inflation without having a World War as a result. Inflation makes everything seem more expensive and is particularly hard on those who live on fixed incomes. It certainly makes foreign imports more expensive but makes domestic exports cheaper leading to improvements in the balance of trade. Clearly, the rate of inflation has a lot to do with the ultimate impact. If prices grow at a slow to moderate pace it is not particularly problematic. It would be sudden and rampant inflation that would cause the most disruption. The other factor, is if inflation is expected, people demand higher returns to offset the expected devaluation of the dollar, causing borrowing to get more expensive and driving down the market p/e ratios.

Now, in our current scenario, we have seen the economy contract by about 15% over the last 4 quarters. This drop in demand is what has caused the recent deflation. It seems that the stimulus and cheap money policies may be bearing fruit and demand is starting to increase. However, we know that there is significant slack in the economy related to labor and commodities that would offset any significant inflationary trends.

Now, if the dollar continues to fall internationally, it makes American products cheaper and foreign products more expensive. It is possible that increased exports can reduce the slack in domestic consumption and lead to an increase in production, potentially fueling the inflationary fires.

So what will it be? It seems that we are at the bottom of the price reductions and that as demand starts to increase we may see modest price rises. Of course, it will take awhile for these prices to return to pre-recession levels and if we make significant progress in areas such as renewable, domestic energy sources, we may find the amount of dollars going outside the country significantly reduced. We also know that Americans are saving more, and those savings are reducing the amount of money in actual circulation, just as the increased bank reserves are.

So inflation is not guaranteed. I would like to think that as the economy picks up we take an intelligent approach to deficit reduction and debt retirement. The biggest challenges there include the cost of foreign energy and health care. I am pretty optimistic about both of these and think its time we fixed them.