Deflation risk?
Ugh. (That's a highly technical economic term). The U.S. economy expanded at a muted pace during the second quarter of the 2010. Government statisticians calculate that the economy expanded at a mere 2.4 percent annual rate. They also figured that the recession--the deepest and longest since the 1930s--was even worse than earlier believed. The economic news is definitely disappointing. Yes, it's good that the economy continues to expand and, when looking more closely at the data, that business investment is soaring. But it's tough to see the job market improving anytime soon.
But here's what has grabbed my attention, and worry. The GDP report will stoke growing alarms over the rising risk of deflation. The price condition we're far more used to is inflation or an increase in the overall price level. Deflation is a decline in the overall price level. Deflation is an unfamiliar, unsettling bogeyman--with good reason. America's most notorious episode of deflation was also its last--the Great Depression. There was a brief, but largely forgotten, episode in 1955 and another one in 2003.
Of course, many economists and investors still worry about high and rising inflation in the future. Not now, but perhaps in a year or two. Their fear is that inflation will inevitably follow the enormous efforts Washington made to stave off a depression over the past two years. Nevertheless, the inflation rate keeps going lower.
For instance, the GDP report has the core rate of inflation--which excludes volatile moves in food and energy prices--increasing by 1.1% in the April-to-June period from the previous quarter. That's slightly below the 1.2% reading in the first three months of the year. Other major measures of inflation reinforce the picture of little to no price pressure. The 12-month change in the core Consumer Price index is 0.9 percent. It has been below 1 percent for the past three months. (Economists treat the core rate as the underlying trend rate of inflation.)
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The inflation rate predicted by 10-year Treasury Inflation Protected Securities is only 1.4 percent. Of course, investors can be wrong--really wrong. But I find it intriguing that investors aren't that concerned that the Fed is printing money.
St. Louis Fed President James Bullard recently released a new research paper--Seven Faces of Peril--that the U.S. faces the real risk of a Japanese-style deflationary period. Here's an article from the American Magazine concerned about deflation, too.
What's the big deal with changes in the overall price level? Not much if the price changes are modest. But history shows that the economy breaking down when trust in money deteriorates. In a sense, the inflation rate and the deflation rate is a barometer of the economic and social health of a nation. Both are bad at the extremes. The historic record is clear: hyper-deflation, say a 1930s deflation rate of 5% to 10%, is ruinous. Period.
The record is mixed, however, when it comes to mild deflation, say a rate of 1% to 2% a year. Sometimes, mild deflation signals a weak economy that limps along, always vulnerable to bad news. Think Japan. However, it can also signal a vigorous, healthy economy. Think late 19th century America.
In other words, what matters is why are overall prices persistently falling. It's a topic I wrote a book about several years ago.
Here's my take: The global economy is undergoing a remarkable structural transformation of a kind that occurs once every century or two. The world is shifting from an era of structural inflation to one of underlying deflation. The combination of technological innovation, freer trade, out-sourcing, central bankers worldwide dedicated to fighting inflation, a more mature international monetary system, and all the rest act as a brake on price increases.
And this is why I'm so concerned about the recent trend in prices. The underlying price trend is deflationary and now, on top of that, is the downward momentum unleashed by the Great Recession and anemic recovery. St. Louis president Bullard is right: The Fed and other central bankers had better start worrying about falling prices and taking bold steps to combat it.