First Published inTHE NEW REPUBLIC

November 2, 1998

DEFLATION: Don't Panic

Martin and Kathleen Feldstein

For more than a year now, we've been hearing dire warnings about deflation, coupled with calls for the Federal Reserve to cut interest rates sharply to prevent such a fall in prices. The stock market's decline has no doubt contributed to the public's fear of deflation. Ironically, the Federal Reserve's recent small interest-rate cut may also have added to these worries. And Japanese Finance Minister Kiichi Miyazawa recently declared that the deflationary spiral is worldwide.

We see things differently. There is at present no deflation either in the United States or in the world economy as a whole. And, looking to the future, the likelihood of deflation remains remote, even if there is a recession in the next year. There have been seven U.S. recessions in the past 40 years, and prices have continued to rise in every one of them. If we had to bet, we'd say that the U.S. rate of inflation a few years from now will be higher, not lower, than it is today.

Deflation is the opposite of inflation and shouldn't be confused with "disinflation." An economy experiences deflation when the overall price level falls. That's different from "disinflation," which means a decline in the rate of inflation. The United States has benefitted from disinflation since the early '80s with inflation declining from more than ten percent then to about four percent in the early '90s and about two percent in recent years. But this nevertheless remained a time of inflation, not deflation.

Changes in the level of the stock market are also distinct from changes in the prices of things we buy and use. So the recent fall in share prices doesn't signify or predict deflation any more than the tenfold rise in share prices since the early '80s constituted inflation.

Now to the data. The consumer price index increased by 1.6 percent in the twelve months leading up to August and by 2.2 percent in the most recent three months. That's a low rate of inflation but it is not deflation. Even with an adjustment for the statistical problems that cause the price index to overstate the true rise in the cost of living, the rate of inflation remains positive.

As for the rest of the world, Japan is alone among the industrial countries in experiencing actual deflation, with consumer prices there falling 0.3 percent over the past year and at a rate of 2.2 percent in the past three months. In Europe, inflation is low but positive. Among the emerging markets, China is the outlier with consumer prices down 1.4 percent over the past year. But China's price decline reflects the restructuring of state industries, and China remains very different from the market economies in the rest of the world. Although the "crisis" economies of Southeast Asia are in recession, they are still experiencing substantial rates of inflation, ranging from 5.6 percent in Malaysia to 81 percent in Indonesia. Latin American inflation rates vary widely from Argentina's 1.1 percent to more than 30 percent in Venezuela. This is not global deflation!

So what accounts for the perception of deflation? The most obvious reason is that some prices are falling. Energy costs are the most obvious, with the prices of gasoline and other fuels down about ten percent in the past year in response to the decline in the world price of oil.

Americans are also paying about one percent less for apparel than they did a few years ago. Many manufacturers are very vocal about the fact that the prices that they receive at the wholesale level are actually down significantly. But even these wholesale price declines do not translate into lower consumer prices because of the rising costs of transportation and marketing.

The price of services in general including such things as restaurant meals, transportation, and personal services like haircuts rise faster than the prices of manufactured goods. That persistent difference reflects the fact that most service prices do not benefit from the kind of technical change that helps to lower the prices of manufactured goods. A haircut still takes as many barber minutes as it did a decade or two ago, while the employee time needed to make a car declines every year.

Looking ahead, several indicators lead us to think that inflation over the next few years is more likely to rise than to decline or to turn into deflation. Normally, the acceleration in wage and salary increases that has occurred over the past few years would have translated into higher consumer prices already. But the fall in world oil prices and the rising value of the dollar relative to other currencies have depressed import prices and put downward pressure on domestic prices. The restructuring of health care has reduced health insurance costs, an important part of total employee compensation. Finally, unusually rapid productivity gains have kept unit labor costs from rising in line with wage inflation.

These anti-inflationary forces are coming to an end. The dollar's rise has been reversed with sharp falls relative to the yen and the European currencies. There are signs world oil prices will rise over the next year. Health care costs appear to be rising more rapidly again. And the higher productivity growth rate that has kept unit labor costs down is probably reverting to its earlier low level.

The expected slowdown in economic activity in 1999 will help restrain the rate of price increases, but the most likely market pressures will still be for inflation to be higher a year from now than the 1.6 percent inflation rate of the past year. Even if a credit crunch or some external surprise to the economy does lead to a recession, we would continue to see positive inflation. Only in the extreme case of the economy falling into a deep depression like that of the 1930s with an unemployment rate above ten percent would the level of prices actually begin a sustained decline. But there is no reason to believe that such a depression is coming. And, at the first sign of a major credit crunch or outside shock, the Federal Reserve would take the further steps necessary to raise total demand.

Deflation, like inflation, does not just happen. The behavior of prices reflects the monetary policies of the Federal Reserve. Inflation rose from about two percent in the 1960s to more than ten percent in the early '80s because the Federal Reserve was then unwilling to raise interest rates enough to halt the inflationary spiral. Only when inflation got bad enough in the early `80s did the Fed bite the bullet and accept the costs, in terms of high unemployment, of reversing several decades of inappropriate policies.

By comparison, fighting deflation would be much easier. Cutting interest rates stimulates economic growth, raises employment, and, by lowering the relative value of the dollar, makes American products more competitive internationally. If deflation ever becomes a serious threat, we have little doubt that the Fed would act decisively. And, if Fed policy alone were not enough, the administration and Congress would willingly join in the tax cuts needed to stimulate demand.

Japanese efforts to reverse deflation have failed because the government there has been unwilling to deal directly with the banking crisis and to cut taxes to stimulate consumer demand. Experience shows that America wouldn't make those mistakes.

There are many economic problems to worry about today and for the future. But deflation is not one of them.