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Wednesday, June 10, 2009

Deflation, Inflation, or Both?

Deflation, inflation, and at their crossroad stagflation, which takes the bad from both and throws the good away. Very simplistic, deflation is driven by surplus of products and means cheap prices and loss of jobs, while inflation is driven by demand of products and means rising wages and rising prices; stagflation comes when loss of jobs persists and prices start to increase.

Robert J. Samuelson in Newsweek:

To make sense of today's most perplexing economic debate–whether we're flirting with inflation or—deflation—it's worth recalling what happened after World War II. Under intense political pressure, President Truman lifted wage-price controls. All heck broke loose. Suppressed during the war, wages and prices exploded. Autoworkers, steelworkers and others went on strike for higher pay. In 1946 and 1947, consumer prices rose 8.5 percent and 14.4 percent, respectively.

What's instructive is that prices then stabilized. There was no wage-price spiral as occurred in the 1960s and 1970s. True, a mild recession in late 1948 and 1949 helped temper price increases. But inflation subsided mainly because people didn't expect it to continue. They'd lived through the Depression, when prices declined. Except for wars, American prices were usually fairly stable.

The lesson for today: psychology matters. What economists call expectations shape how workers, managers and investors behave. If they fear inflation, they act in ways that bring it about. The converse is also true, as the late 1940s show. The lesson provides context for today's debate. Are the Federal Reserve's easy-money policies laying the groundwork for higher inflation? Or will these policies prevent deflation– a broad decline of prices–that would deepen the economic slump?

These questions arise from the Fed's strenuous efforts to support the economy. It has cut the overnight Fed funds rate almost to zero. It has made loans when private lenders wouldn't–in the commercial paper market, for instance. To lower long-term interest rates, it's pledged to buy $1.25 trillion of mortgage securities backed by - Fannie Mae and Freddie Mac and $300 billion of long-term Treasury bonds. These meas-ures are without modern precedent.

Precisely, say the inflation worriers. Once the economy recovers, the easy money and credit will spawn inflation. Cheap loans will bid up prices; wages may follow. Low interest rates will encourage spending and deter saving. The Fed will be under pressure from Congress, the administration and business to prevent interest rates from increasing, warns economist Allan Meltzer of Carnegie Mellon University. With huge budget deficits, the White House and Congress will want to keep borrowing costs down. Inflation psychology will take hold.

Nonsense, say deflation worriers. Inflation results mainly from too much demand chasing too little supply. Today, too much supply chases too little demand. High unemployment and slack business capacity (idle factories, vacant office suites, closed mines) impede wage and price increases. If the Fed doesn't maintain cheap credit, shrinking demand might cause prices and wages to spiral down. Deflation, not inflation, is the clear and present danger, retorts Princeton economist and New York Times columnist Paul Krugman.

It seems impossible for both arguments to be correct, but they may be. As Krugman notes, inflationary pressures are almost nonexistent. In the past year, the consumer price index has been roughly stable. In May, the unemployment rate rose to 9.4 percent. A survey by Challenger, Gray & Christmas found that 52 percent of firms had frozen or cut salaries. GM's bankruptcy is but one indicator of excess industrial capacity. The surplus is worldwide, finds a study by economists Joseph Lupton and David Hensley of JPMorgan. Inflationary expectations are low.

All this gives the Fed maneuvering room. Expectations matter; inflation won't burst forth instantly. Even Meltzer doesn't see an immediate surge. When will it come? Surely not right away, he writes.

Still, his warning remains relevant. The Fed has often overdone expansionary policies and fostered inflationary expectations. In the 1960s and 1970s, that occurred through excess demand and a classic wage-price spiral. The danger now might emerge through exchange rates and commodity prices. Inflation fears could raise prices of commodities (oil, metals) and depress the dollar. Imports would become costlier, allowing domestic producers to raise prices. Once inflationary practices take hold, high inflation and unemployment can coexist: dreaded stagflation. In 1977, both inflation and unemployment were about 7 percent.

There's evidence (better housing and auto sales, stronger growth in emerging markets) that the danger of a deflationary economic free fall is ebbing. Someday, the Fed will have to raise interest rates. Fed chairman Ben Bernanke has pledged to preempt high inflation. Will the Fed get the timing right and resist political pressures? Will his pledges reassure markets?

One reason they might not is that Bernanke's term as chairman expires in January. Any replacement named by President Obama would be seen, fairly or not, as more beholden to the administration. The president should eliminate that perception by reappointing Bernanke. That would not settle today's deflation-inflation debate, but it would remove a needless uncertainty.

(Zoon Politikon)



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