Some people in the media are freaking out about the possibility of steadily and/or steeply falling prices, i.e., deflation. So I figured out what kind of deflation was currently being expected by those in financial markets.
I calculated the expected inflation rate implied by the difference between the rates on constant-maturity non-indexed 5-year government bonds and the inflation-indexed version of the same bonds. This number was steady at between 2 and 3 percent per year from 2003 to early July of 2008, which in general fits with the inflationary experience of the time. Then, there was a sudden fall. (What happened on July 2 or thereabouts?) As of November 20, it was –1.79%!! It's not just the media. The finance types are also freaking out.
Why is deflation a bad thing? Part of it is if people expect prices to fall, they delay purchases. Also, if prices are falling steadily, people don't want to borrow because the real value of their debts would rise. It's the opposite of the case of the inflationary 1970s, when people wanted to borrow a lot because the debts would lose value over time.
In looking at loans economists use the "real" interest rate, which is the nominal or money interest rate minus the expected inflation rate. Suppose I pay 4% interest on a loan. At the same time, inflation is barreling along at 2% per year and I expect it to do so in the future. That means the money I'm paying my loans back is losing 2 percent of its purchasing power each year. Thus, I subtract the inflation rate (2%) from the nominal rate (4%) to get the real rate, the interest rate in constant purchasing-power money (2%).
If the inflation rate that people expect goes from 2% per year to -2% and the interest rates appearing on loan agreements stays put at 4%, the real interest rate rises from 2% to 6%. And it's this rate that counts in determining decisions. The nominal rate can fall, of course, counteracting this. But it can't fall below 0. After that, increasing rates of deflation mean rising real rates.
Rising real rates make the recession worse by discouraging borrowing and spending. Recession then encourages further deflation. It can be a vicious circle.
It’s more than a matter of expectations. If people are locked into long-term loans with constant nominal interest rates and amortization rates on principal, and if nominal wages and salaries generally fall with prices, that means that debt service rises relative to wages due to deflation. If general enough, this phenomenon encourages bankruptcy.
Key to the last paragraph is the assumption that nominal wages and salaries fall with prices. A “true” deflation can be distinguished from a minor one by saying that in a true one, we see a wage/price spiral going downward. If wages and salaries don’t fall as quickly as prices, on the other hand, a mild deflation causes profit squeezes. Both are unpleasant in a capitalist economy.
as per usual, I'm posting a comment on my own blog so that responses will be forwarded to my e-mail.
There are other effects as well. For example, deflation results in an automatic increase in the value of the minimum wage, and people on fixed incomes, such as retirees on Social Security, have more spending power. In fact, if you have a 3% CD, you might suddenly have a 5% CD, and after years of negative real interest rates, that might lead to more spending. The people who really get bonged are the people who bought assets at bubble prices.
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It seems that the Obama express is on the right track. When depression and deflation threaten you stop squirting money all over the banks and you start spending money at the bottom -- stimulus. The bailout of the financial sector is a problem for the Fed and the banking system. The real economy runs on real money. Real money is created when government spends it into existence and it is destroyed when it is taxed back out of the economy. Today the dollar lost 2 cents against other currencies (that's a lot for one day).
Since last Thursdays' close, Feb. 09 gold is up $75 an ounce. Jan. oil is up $4.50 a barrel. That is the real stuff. Dollar devaluation (inflation -- no deflation) will be needed if depression is to be avoided. Stimulus does that. There is no "trickle down" solution and never has been.
The dollar had GAINED 16 cents between July and last week. That is a killer for trade imbalance and it was a major reward to China. "We have nothing to fear but those who want to bail out the financial weenies".
Well, actually that rise of the dollar has been against the euro and most other world currencies, but not against the Chinese rmb/yuan. Nor against the Japanese yen, which for once are going in the direction they should.
It is bizarre how great the disagreements are out there over which way prices are headed. I just spent a weekend at the Southern Economic Association meetings, where there was a panel on Federal Reserve policies. Most of the panelists were all over the Fed for being too inflationary, although former Fed governor Wayne Angell strongly defended Bernanke.
Excellent post! The idea that falling prices in a recession/ depression is part of a self-correcting negative feedbask mechanism - an idea that is at the core of standard macro: RBCers and so-called New Keynesians agree on this, the latter simply offering reasons why prices won't easily fall - is,as Keynes was at pains to point out, rubbish.
Kevin, thanks for your support. The late James Tobin and others have been highly critical of the mainstream "price declines will solve recessions via wealth effects" crap for a long time. The profession only seems to care during severe recessions.
By the way, my estimate of the deflation that financiers expect (an expected inflation rate of –1.79%!!) is obviously exaggerated. As Dean Baker points out, there's also a liquidity premium because of the narrowness of the market for inflation-indexed bonds. But financiers are expecting a massive down-shifting of inflation.
That nominal rates could be below real rates so surprised me that I had to check here:
True but the 5-year and 7-year with 10-year rates nearly the same. So are markets forecasting that the price-level will dip and then return to 2008 levels by 2018? For the 20-year spread, it looks like expected inflation is still below Bernanke's target rate. Ben? Expand the money supply - QUICKLY and OFTEN!
When "expanding" the money supply it is important as to who gets the money first. If the Fed whips up a bunch of money and gives it the the financial hucksters, as is the current Fed methodology, then the hucksters get richer and that is the end of the story. The money does not "trickle down" at all. If, however, money is added to the economy by infrastructure development then the additional money does some good.
But this is not the job of the Fed. It is the job of the elected government. And that the hucksters are getting richer at the expense of the common people is the fault of Republican trickle down pseudo economics and the trained seals in the "neoclassical school".
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