Mon, April 13, 2009
Inflation or Deflation – Which Do We Have? (Part II)
Previously I discussed some of the differences between inflationary and deflationary economic environments. I’d like to pick up where I left off, mention one challenging aspect of deflation, and talk a bit about which environment we’re experiencing.
A major problem with deflation is that it can be difficult for a central bank to control. When inflation is high, the Federal Reserve can raise interest rates, and this tends to slow down inflation. But if prices are falling consistently, the Fed would normally like to stimulate the economy by making it easier to borrow money. The lowest rate the Fed has at its disposal is 0%. Presently the Federal Funds rate (the interest rate banks charge each other for loans) target range is 0.25% - 0%. Once the central bank lending rate is at 0%, it can’t go any lower; a negative Fed Funds would mean that Bank A lends X dollars to Bank B and gets back fewer dollars when the loan is repaid. No bank would do that, of course. In such a situation (like now), the central bank appears to be out of bullets.
Something that I should have mentioned before is that inflationary or deflationary effects need not occur everywhere at the same time. Asset prices and the costs of consumable goods, services, and wages don’t have to go up or down in lockstep, and often they don’t. Moreover, although you might think that periods of economic contraction would necessarily coincide with deflation (as in the Great Depression), in the 1970’s the US experienced “stagflation:” economic malaise plus inflation. It was almost as bad as bell-bottomed pants.
Are We Experiencing Inflation or Deflation Now?
At the moment, there are definite signs of deflation in asset prices (stocks, houses), energy prices (down 19% versus last year as of February), and industrial commodity prices. There’s anecdotal evidence of wage deflation in the US as several companies have announced pay cuts.
Federal Reserve Vice Chairman Donald Kohn has publicly expressed concern that the US could enter a Japan-like deflationary spiral. The Fed’s Open Market Committee currently considers inflation to be a non-concern; their current fear is the risk of deflation. Through the end of last year, there were definite declines in the overall consumer price index, but current price trends are ambiguous.
The Fed is Fighting Deflation: Quantitative Easing
Fed Chairman Ben Bernanke, in a speech on Japanese monetary policy in 2000, argued that when interest rates are zero, monetary policy can still influence price increases (and hence, stem deflation) through dramatic increases in the supply of money. Bernanke also noted in his speech that deflation is more dangerous now than it was in earlier eras becuase the levels of leverage in use today are much higher. Borrowers lose out during deflationary periods because the face value of their indebtedness remains the same while the value of their assets declines; at higher levels of leverage, the effect is much more severe (For an example of the way that leverage magnifies losses, see this post on hedge fund losses).
The practice of printing money when interest rates are at or near zero is known as quantitative easing. The Bank of Japan began trying this policy in 2001, and the jury is still out on the question of whether it has had the desired effect of stimulating the Japanese economy. As of March, Japanese wholesale prices declined 2.2% versus last year; it’s difficult to say whether things would have been worse without quantitative easing.
Heeding the call, “physician, heal thyself,” Bernanke has been taking the advice he gave the Japanese. The announcement that the Fed would start buying up to $300 billion in Treasuries signaled the central bank’s serious commitment to quantitative easing. The Bank of England and the Swiss National Bank have made similar moves.
The question prompting a fair amount of debate right now is whether the Fed’s actions, coupled with stimulus spending, will cause prices to heat up and lead to serious inflation. Put another way, should we be more worried right now about the risk of inflation or that of deflation? At the G20 economic summit, inflationary concerns left German and French monetary officials rather cool to the idea that they should be boosting government spending to stimulate their economies. The Germans have a strong ancestral memory of hyperinflation during the Weimar Republic, and the fear of a return to those years is doubtless as strong as American fears of another Great Depression.
My own gut feeling is that the Federal Reserve will not be able to tweak the economy perfectly; the Fed’s tendency, whether hitting the gas or the brakes, is to respond after the fact. If the Fed precipitates inflation, it won’t know it right away. So I think inflation is the greater concern in the long run, but in my next post I’ll discuss how different investments can be expected to fare in both inflationary and deflationary environments.
RELATED POSTS:
Inflation, Deflation, Disinflation – What’s the Difference?
Investing for Inflation vs. Deflation:Asset Classes (Part III)