Falling Prices Put Fed on Guard
Policymakers Talk About Dangerous Dynamic for Economy
By Steven Pearlstein
Washington Post Staff Writer
Friday, November 29, 2002; Page A01
After half a century of trying to prevent prices from rising too fast, economic policymakers have a new concern: Prices aren't rising fast enough.
Government statistics show that average prices for products have declined in the past year, including those of cars, clothing, computers, furniture, gasoline and heating oil. So, too, have the prices for services such as telephones, hotel rooms and airplane tickets, even as costs for other services such as health care, housing, education and cable television continued to rise.
The broadest measure of prices in the economy shows they rose less than 1 percent during the 12 months that ended in September, the smallest increase in 50 years.
Until now, the slowdown in overall inflation has been a boon to the American economy, giving consumers more for their money and allowing living standards to continue to rise even during a period of slow economic growth.
But economists warn that if disinflation turns into deflation -- a broad and sustained decline in prices -- it would create a dangerous dynamic that could drag the economy into a nasty recession from which it could be difficult to escape.
"If you had asked me a year ago, I would have said it was ridiculous to worry about deflation," said Alan S. Blinder, a Princeton University economist and former vice chairman of the Federal Reserve. "But the prospect of deflation is now sufficiently probable -- I'd say 15 to 20 percent -- that it's now worth talking about."
There has been quite a bit of talk about deflation lately.
In recent testimony before the Joint Economic Committee of Congress, Federal Reserve Chairman Alan Greenspan said that while the economy is not yet "close to a deflationary cliff," he and his central bank colleagues are watching it closely and taking it very seriously. Last week his fellow Fed governor, Ben S. Bernanke, followed up with a deflation speech titled, "Making Sure It Doesn't Happen Here."
Corporate executives complain that price competition is so fierce, they are forced to cut prices even as wages and other costs continue to rise.
And on Wall Street, declining long-term interest rates in the bond market signal that investors are not much concerned about renewed inflation.
Deflation, like cholesterol, comes in good and bad varieties.
The good kind, such as many of the price declines over the past few years, happens when companies find ways to produce goods and services more cheaply, usually by making use of new technology or new ways of doing business. In varying degrees, these productivity gains are passed on to consumers as lower prices, to workers as higher wages and to shareholders as higher profits. That makes almost everyone better off.
By contrast, the bad kind of deflation occurs because there are too few customers chasing too many goods and services, resulting in repeated rounds of competitive price cutting that leads to layoffs, falling wages, and a decline in business investment and consumer spending.
During bad deflation, consumers and businesses -- knowing that prices are likely to be lower tomorrow than they are today -- hoard cash and put off buying things, making the recession worse and driving prices and wages down further.
Households and companies with lots of debt suddenly find that they have to make fixed monthly payments out of deflated wages and revenue. Some file for bankruptcy; some are forced to cut other spending to meet their debt service.
That was what happened in the early 1930s, triggering the Great Depression. Something similar has taken hold in Japan, where prices are falling about 1 percent a year.
What worries some economists is that in both of those bad episodes, the deflationary spiral occurred after a huge investment bubble burst, leaving the economy with too much debt and too much capacity across a broad range of industries.
Stephen S. Roach of Morgan Stanley argues that some of those dynamics are now at play in the U.S. economy after the worst stock market losses since 1929.
"The risk of deflation is higher than at any time in the past half century," Roach said.
Americans can already see a few early signs of bad deflation taking hold in a number of industries -- Wall Street, commercial real estate, much of the technology and telecommunications sectors. Perhaps no industry shows it more clearly than the airlines.
Take the example of United Airlines, which is cutting expenses in hopes of getting federal loan guarantees and avoiding a bankruptcy filing. As demand for air travel fell, United was forced to reduce fares by roughly 4 percent in the past year, offering more and deeper discounts to fill empty seats. More recently, a war over business-class fares threatens to slash ticket prices by as much as 40 percent.
With sales that depressed and prices that low, UAL Corp., United's parent company, is likely to lose more than $2 billion this year. It has already cut 18,000 jobs and plans to trim 9,000 more in the next year, for a cumulative payroll reduction of more than 25 percent. Moreover, the employees who remain have been asked to accept wage and benefit cuts that would save the company $5.2 billion over 51/2 years, or an average of about $12,000 per worker. Pilots have agreed to pay cuts of 18 percent, with a 10 percent cut imposed on management personnel. Machinists, though, rejected pay cuts of 6 to 7 percent.
Now deflationary forces have spread to major suppliers. United has canceled or deferred delivery of 68 new airplanes, with none to be delivered until 2005. Such actions by United and others led Boeing Co. to cut its payroll by 30,000, with an additional 5,000 layoffs announced earlier this month. At the same time, Boeing is in a fierce price war with Airbus SAS to snare what few remaining orders there are.
Although other industries have experienced declining prices and shrinking payrolls, they have not led to the declines in employment and wages that most economists believe are necessary to create and sustain a broad deflationary spiral. That could change, however, if the current recovery falters and the economy dips back into recession.
"If we have a double-dip [recession] and consumption and investment both weaken again, then that is the road to deflation," said John H. Makin, an economist at the American Enterprise Institute.
The Federal Reserve was worried enough about that prospect that it lowered interest rates this month by half a percentage point. In recent speeches, Fed officials emphasized that there is plenty they can do to prevent a deflationary spiral even if they push the federal funds rate down to zero and need still more monetary ammunition.
Fed officials have been thinking about how to conduct monetary policy in a deflationary environment since the fall of 1999, when the Federal Reserve Bank of Boston hosted a conference on the subject in Woodstock, Vt. Late last year the Fed's research staff, in a paper on Japan's experience, concluded that a deflation spiral was so difficult to forecast, and so difficult to stop after it began, that the Fed should move aggressively before inflation hits zero. According to its minutes, the Fed's policymaking body took up the subject this past January and at its meeting in September.
"The Fed takes this very seriously," said Adam S. Posen, a senior fellow at the Institute for International Economics. "They will do what it takes. But the truth is it won't be needed because deflation is not going to happen here."
In explaining his confident view, Posen noted that the two instances in which deflationary cycles developed in the 20th century -- the Great Depression in the United States and Europe and Japan during the 1990s -- central banks were too timid about using their money-printing powers. In both cases, the bursting of a financial bubble rendered the banking systems effectively bankrupt, drying up new credit for businesses.
In contrast, U.S. banks today remain profitable and well capitalized, in spite of their significant post-bubble losses and write-offs, Posen said.
Back at Morgan Stanley, however, Roach warned of the dangers of refighting the last war and expecting things to unfold here just as they have in Japan.
Already, the rate of disinflation since the peak of the boom years is running about five times that of other recent recessions, Roach said, with no sign that the deceleration is abating.
And this time the deflationary pressures are coming not just from within the U.S. economy, but increasingly from low-cost countries that export a wider range of goods (auto parts, furniture and computers) and a growing number of services (computer programming and telemarketing).
In such a global economy, Roach said, the Fed's ability to boost prices by printing unlimited amounts of money is matched against the ability of countries such as China and India to deploy virtually unlimited numbers of workers to burgeoning export industries. That makes deflation a problem not only for Japan or the United States, but also for the rest of the world.
"The endgame of global deflation cannot be dismissed out of hand," Roach said. |
