JUNE 10, 2010
Deflation Fears Stir in Developed Economies
By JON HILSENRATH
Worries about consumer price deflation are resurfacing in the world's developed economies after weeks of financial-market turmoil driven by Europe's fiscal crisis.
The fears are most pronounced in Europe, where policy makers are under pressure to reduce large budget deficits now, before durable recoveries emerge. A combination of spending cuts and tax increases could weigh on economic growth and feed into deflation, which is a broad decline in consumer prices.
Deflation makes it harder for consumers, businesses and governments to pay off debts. Principal repayments on debt are fixed but deflation is marked by falling incomes, so as deflation sets in the burden of paying off old debts gets greater.
Officials fret about deflation because it is hard to stop. Interest rates are already near zero in the U.S. and elsewhere, so policy makers can't use the traditional tool of rate cuts to spur growth and stop deflation.
That's an acute worry today. In addition to government debt, U.S. households are still trying to work off large debt burdens built up in the last two decades. A Federal Reserve report Thursday showed households cut their borrowings in the first quarter to $13.5 trillion, down from a peak of $13.9 trillion in 2008.
One leading indicator, Ireland, which has already experienced deflation amid severe fiscal austerity, reported Thursday that consumer prices were down 1.1% from a year earlier in May, though the declines have moderated in the past few months.
In the U.S. the threat looks more remote, but economists are beginning to warn that if the recovery falters, the risk of a deflation bout will increase.
In one sign of rising alertness to the threat, yields on 10-year Treasury bonds—which fall when inflation worries recede and rise when inflation worries increase—have dropped from nearly 4% in early April to about 3.3%.
Though yields firmed a bit Thursday, big bond houses like Pacific Investment Management Co. have been moving into the safe-haven instrument.
"There are clear warning signs of deflation," Anthony Sanders, a George Mason University professor, warned at a Federal Reserve conference about housing in Cleveland Thursday. "My friends at the [Federal Reserve] may not agree with me. If the banks don't lend, we will get deflation."
Policy makers in the U.S. and elsewhere have been worrying about deflation for much of the past decade. The Fed's low-interest-rate policies of the early part of last decade were designed in part to avoid it. So far, it hasn't taken hold in any large economy outside of Japan. And in developing economies, inflation driven by overheated growth remains the primary concern—officials in Brazil raised interest rates by 0.75 percentage point Thursday to 10.25% to contain growth.
The Fed's own efforts in the past few months have been geared toward reassuring a skeptical public that inflation, not deflation, wouldn't be the next threat after it pushed interest rates to near zero to combat the recession. Inflation is still slowing sharply. U.S. consumer prices were up 2.2% in May from a year earlier and could tick lower as food and gasoline prices fall. Excluding the volatile food and energy sectors, consumer prices were up just 0.9% in May, the smallest increase since 1966.
Consumers never seem to see price declines in certain categories like education and health. For instance, prescription drug inflation picked up during the recession to 5% from less than 3% in 2007 and 2008, according to the Bureau of Labor Statistics. But in some basic services, price increases are slowing sharply. The cost of pet grooming, for example, slowed to a standstill in April from a year ago after rising by 4% or more a year through much of last decade.
Mark Gertler, a New York University economist and a former co-author with Fed Chairman Ben Bernanke, says he expects the economy to grow at a rate between 3% to 4% and sees inflation in the 1% to 1.5% range, "but I would tilt the disaster risks more toward deflation than inflation."
The Fed is hoping that it has fought inflation to a standstill by pushing interest rates to near zero and pumping more than $1 trillion into the financial system through loans and bond purchases. While all of that money could in theory cause inflation, weak banks and the immense amount of slack in the economy are weighing against that.
Subtle hints of wariness about deflation have crept into the talk of some officials. In a speech Wednesday, Brian Sack, who runs the Federal Reserve Bank of New York's powerful markets group, said U.S. officials needed to be as worried about the risks of inflation falling too much as they are about the threat that prices could soar. "I think the concerns about inflation should be two-sided," he said, meaning the upside and the downside.
Similar worries are being voiced at the Bank of England, even though inflation in the U.K has been on an upswing. "The U.K. and U.S. economies are at low risk of turning Japanese in the sense of having recurrent recessions through macroeconomic policy mistakes—but deflation itself cannot be ruled out," Adam Posen, a member of the central bank's monetary policy committee and an expert on Japan's deflation, said in a speech in late May.
Fed chief Bernanke noted Wednesday that even though gold prices have been soaring—a potential indicator of inflation fears—many other inflation indicators are going the other way, including yields on U.S. Treasury bonds and prices for commodities. The price of copper, for instance, is down 22% since early April. The average price of regular unleaded gasoline in the U.S. is down 19 cents from a month ago, according to AAA.
Fed officials are just as concerned about what people think inflation will do in the future as they are about what it has already done. If people start to believe that inflation will rise or fall sharply, their behavior can point actual inflation in the direction they're expecting.
At the Baltimore-based trucking firm Cowan Systems LLC, expectations are being pulled in two directions. Joe Cowan, the firm's president, says the rates his company charges are 15% to 20% below where they were in 2007.
"There's too many trucks chasing too little freight," Mr. Cowan says.
But he thinks a turnaround could be brewing because many small trucking companies have gone out of business and those that remain will be able to negotiate higher rates.
And wage pressures could be building. "I can't get the drivers now," he says.
Financial markets suggest investors are torn about inflation risks too. Prices for gold—which some investors buy as an inflation hedge—have soared, suggestion inflation worries are mounting. But expectations as measured in the market for Treasury Inflation Protected Securities, or TIPS, have been mostly stable and softened a bit in recent weeks. Yields on these instruments imply investors expect 2.7% inflation five years from now. This is down from 3.1% seen in April.
Another wild card is the behavior of the dollar, the euro and other currencies. Carmen Reinhart, a University of Maryland professor who has studied financial crises over eight centuries, said deflation isn't a common characteristic because of currency movements. Currencies often fall in value after a crisis, which puts upward pressure on inflation, forestalling deflation even though they cause other problems.
"It is hard to make a tightly sealed, well-thought-out case that deflation is around the corner on a sustained basis," Ms. Reinhart said. The fall of the euro could save Europe from deflation, she said, adding that the Fed's aggressive pump priming will likely keep the U.S. out of it too.
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