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YOU DECIDE: Should you hope for deflation?

January 09, 2009

MEDIA CONTACT: Dr. Mike Walden, 919.515.4671 or michael_walden@ncsu.edu


Dr. Mike Walden
Media representatives:For a black-and-white or color copy of this photo, call 919.513.3127 or e-mail dave_caldwell@ncsu.edu.

For the first time in 70 years, the most widely followed measure of inflation (the Consumer Price Index) showed average prices falling for four consecutive months. Even the inflation index that excludes gas prices - which have been plunging - fell in November. Are these signs of deflation, and if so, should you be happy about it?

Before answering, let me define some terminology. Inflation means average prices are rising. Importantly, the average is a "weighted" one where products and services that are more important to consumers' spending receive greater importance than those that aren't. The inflation rate is then reported as a percentage, like 2 percent or 3 percent. A 3 percent inflation rate means average prices rose 3 percent for the time period covered (usually a year, or if it's a month, annualized to a year).

Deflation is the opposite of inflation. Deflation means average prices are falling. A deflation rate is also indicated by a percentage, except now the percentage is negative. So a deflation rate of -2 percent means average prices fell 2 percent for the year.

It is very unusual for deflation to occur. Since World War II, deflation has happened less than one-tenth of the time.

When deflation does occur, it's usually during bad economic times, such as a recession or depression. Indeed, the granddaddy of all deflationary periods happened during the economic depression of the 1930s, when prices fell more than 20 percent.

This makes sense. During economic downturns, consumers buy less, or at least their spending rises at slower rates. This means that to move their merchandise, retailers and merchants will discount prices and put things on sale; in other words, they'll lower prices. From the perspective of sellers, it's better to make some money than none at all.

So shouldn't we all be jumping for joy when deflation is reported? After all, it means what we buy at the malls, shopping centers and supermarkets is cheaper, so our paycheck will go further. What could be wrong with this?

What could be wrong focuses on one key word in the above paragraph: paycheck. If companies are earning less money from what they sell, then they'll have less money to pay workers. Historically, there has been a very close relationship between how fast prices rise and how fast wages rise. When prices go up more, so do wages, and when prices go up less - or drop - wages follow.

Therefore, if the economy gets into a prolonged deflationary cycle, our paychecks will probably also slide. Yet such a situation wouldn't necessarily result in a lower standard of living. If what we earn is less, but the prices of what we buy are also less, then the result can be a wash.

Except in one aspect of our financial lives: debt. Payments on debt are different in that they are usually specified as dollar amounts; for example, $300 a month for a car loan or $800 a month for a home mortgage. And unless the loan is tied to a floating interest rate, the payment won't drop when there's deflation.

So this means a consumer, whose income might be falling due to deflation, would still owe the same monthly payment on her loans. Obviously this increases the chances the consumer couldn't meet the payments, making default on the loans and loss of the car or home a greater possibility.

Clearly the economy doesn't need more loan defaults and home foreclosures now. This is why many economists think a long period of deflation isn't likely for one big reason: the government will prevent it. The government, in the form of the Federal Reserve, does have the ability to hold off deflation by simply printing more money. The Federal Reserve has already hinted at its intent to do just this.

So you'll have to decide if you're better off with deflation. If you are, enjoy it now because it likely won't last. In fact, with the money printing presses working overtime today, our worries will likely turn back to inflation in a couple of years!

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Dr. Mike Walden is a William Neal Reynolds Professor and North Carolina Cooperative Extension economist in the Department of Agricultural and Resource Economics of N.C. State University's College of Agriculture and Life Sciences. He teaches and writes on personal finance, economic outlook and public policy. The Department of Communication Services provides his You Decide column every two weeks. Earlier You Decide columns are at http://www.cals.ncsu.edu/agcomm/writing/walden/decide.htm

Related audio files are at http://www.ncsu.edu/waldenradio/

Posted by Dave at January 9, 2009 08:47 AM