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U.S. consumer prices fell unexpectedly in March and recorded their first annual drop since 1955, government data showed on Wednesday, as slumping demand pushed down energy and food costs. [Reuters]
Falling prices? It's like a national fire-sale. What's not to like?
Plenty. We know all about inflation, of course. Rising prices are intuitively bad, and people still remember the inflationary 1970's. But deflation is a distant memory. It hasn't been a problem for decades. Eight decades in fact. The last time the U.S. faced severe deflation was during the Great Depression, when prices fell at 10% annually. And the most recent example of severe deflation in the industrialized world occurred in Japan in the 1990's, as the country suffered through a decade-long recession.
There are several problems with deflation. First, the value of illiquid assets like homes falls, so current home owners literally lose wealth. Second, the cost of debt increases. Imagine that the interest rates on home mortgages drops to zero, so you buy yourself a $500K house. At 10% deflation, that home is worth $450K the next year, so you've effectively paid $50K for the debt, even though there was no interest.
The deflationary cost of debt coupled with the expectations of lower profits discourages consumers and businesses from spending and investing. Why buy a house now, even at zero percent interest, if it will be worth less than what you bought it for in a year? With lower demand, prices drop further, which further discourages spending. This is the deflationary spiral that triggered the Great Depression.
In addition, credit is the fuel that drives the economy, which is why the government is spending so much to persuade the banks to start lending again. But the government must also persuade individuals and businesses to take the loans. Normally, it accomplishes that by lowering interest rates, a key recession-fighting tactic. But if the cost of debt and low profit expectations discourage investors from taking loans even at effectively zero interest, then the government's most reliable recession-buster is rendered impotent. This is the liquidity trap that Paul Krugman has been warning us about and which Japan faced in the 1990's.
It's not time to panic yet. There are signals that the economy is improving, and while prices dropped in March, they rose in January and February. But do be concerned, and be aware that low prices are not necessarily a good thing.