Inflation vs Deflation : Which Is The Bigger Evil ?
Traditionally economists and policy makers as well as the man on the street worry about inflation and not so much deflation (which to many just mean cheaper prices) but lately the talk has swung around to deflation being the bigger of the two evils as the world economies shrink and people lose their jobs as a result.
This post looks into which of these two monsters are likely to prevail in the short-medium and long term and also what the experts have to say about each as governments right now ready themselves to fight the deflation monster.
A Reuters article has this quote on the issue :
“Deflation is as dangerous as inflation, and we will take every step to counteract it,” Richard Fisher, president of the Federal Reserve Bank of Dallas, told reporters after a speech at Bryant University in Smithfield, Rhode Island.
So while deflation seems to be the present evil Mr Fisher is very aware of the fact that soon he could be figthing inflation again :
As companies across the country cut jobs and consumers spend less, many economists are worried about the potential for a sustained decline in prices.
The Dallas Fed calculates price pressures based on personal consumption expenditures, or PCE, and in the bank’s December report, the bank found that more than 50 percent of the market basket was going down in price, Fisher said.
But Fisher cautioned it was far from certain whether this decline will continue in coming months.
“There are price pressures on the downside, but we will make sure that deflation does not take hold,” Fisher said.
At the same time, Fisher said U.S. central bankers are keeping a watchful eye on inflation. Some economists have voiced concern about the potential for inflation down the road as the Fed has cut interest rates to near zero and pumped hundreds of billions of dollars into the financial system to unfreeze key credit markets.
Mark Crosby of TheAge.com.au has these comments to make on the subject :
Two questions that arise are what is the purpose of an inflation target, and why adopt an inflation target now, when there is no sign of inflation?
Inflation targeting started in the late 1970s and 1980s, when the Bundesbank in Germany, and the Swiss central bank used targets for inflation to guide their decisions about growth in the money supply.
At this time, many central banks were targeting the money supply, with the view that reducing money growth would reduce inflation from then high levels. But the Bundesbank was much more successful than other central banks in keeping inflation low, and tended to follow the strategy of using an inflation rate of about 2 per cent to guide its money growth targets.
And the article continues to explain :
Since being given inflation targets, and the independence to pursue these targets, central banks have been very successful in maintaining low inflation.
The main purpose of explicit targets is to anchor expectations of businesses and unions: if businesses believe that inflation will stay at around 2 per cent they will tend to increase prices by around that amount. Similarly unions will know that to increase wages significantly above 2 per cent plus a margin for productivity will put jobs at risk. These expectations of businesses and unions will then help sustain the low inflation target.
The reason for targeting inflation above zero is that there is a feeling among economists that a small amount of inflation “greases the wheels” of the economy. Furthermore, deflation can be very damaging to an economy, and so it is best to keep clear of a zero inflation rate or lower.
John Lonski, who is chief economist of of Moody’s Investors Service, is also more worried about the deflationary economy and explains why :
I’m still more worried about price deflation looking ahead than I am about inflation. We still have a ways to go yet as far as forming a top for the unemployment rate. And I wouldn’t be surprised if to an unprecedented extent, many employers both in the public and private sector decided to freeze wages, if not cut wages.
Senior Economist Milton Ezrati sees the issue somewhat differently :
Well for the short term, for the intermediate term the next six or 12 or even 18 months, I don’t think we have to fear very much either from inflation or deflation. For the longer term, however, inflation is the threat largely because of the tremendous liquidity the Federal Reserve has poured on our markets.
Andy Serwer provides this brilliant overview of the inflation vs deflation issue at hand at The Captain’s Blog from CNN Money :
High inflation is bad of course, but a little bit of inflation is a good thing and actually optimal. A moderate rate of inflation seems to make it easier for businesses to raise prices (which is good for growth) and allows employees to ask for raises. A little bit of inflation also encourages folks to invest their money instead of leaving it in their mattress. On the other hand, deflation, or falling prices, is a bad thing since it causes people to freeze up and delay purchases until prices are lower. This can induce a death spiral of deflation and economic contraction, which is what happened in Japan. Right now economists are much more concerned about deflation than inflation. No question, we are pulling in our spending horn right now, which seems to have eradicated inflation, now the question is, will prices fall?
And he has these words when it comes to what we can expect on price developments in 2009 :
So if you were a betting person, would you wager that prices overall will fall this year? Well, the wild card is energy, but other than that, it’s tough to see prices going up. Just how badly this hurts the economy is a huge unknown. Hey, we made it through 1955, we will most likely make it through 2009.
Christopher Grey of TheStreet.com explains why the US Government is dead scared about the looming deflation :
In just a few months, the Fed has effectively printed trillions of dollars and the Treasury has spent more than a trillion dollars trying to increase the supply of money. That should demonstrate their seriousness about preventing deflation.
According to Grey there is also an even bigger agenda as to why the US Government has a strong incentive to create a strong inflationary economy and hence fight deflation tooth and nail :
Second, it is in the national interest of the U.S. and the personal interest of most American consumers to create inflation. The U.S. government owes trillions of dollars to foreigners. It has a strong financial incentive to destroy the value of the dollar in order to repay that foreign debt with cheaper currency. Similarly, most Americans are deeply in debt and would benefit from inflation that would effectively reduce that debt burden on their households.
Grey finishes off his insight into the inflation vs. deflation issue with some sound reasoning why the consumer should look at inflation as a positive thing and also what can be done now to ensure financial success assuming of course that Grey is right and that inflation will soon prevail :
Another way to benefit from future inflation is to take advantage of low-interest rates and lock in long-term financing to buy income property such as apartments in supply-constrained markets that will benefit from future inflation through increased rental rates and higher cash flow to the owner.
Do not believe the hype about deflation. It could be dangerous to your financial health. Right now is the best time to start hedging against future inflation because most people don’t believe it’s going to happen. Now is the classic time to buy a straw hat in winter, because people are just giving them away.
So let battle commence between these two giants ! It does, however, seem that major economies such as the US, Japan and China have more to lose by allowing deflation to take over from the traditional inflationary economies and hence we should expect strong efforts by Obama and Co to fight deflation on all fronts which hence is likely to be major theme for 2009 and probably also 2010.
