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There's been talk of a possibility of deflation looming. But, is the threat real?

One thing for sure, we've definitely been in an equity market deflation for the past 2 and a half years. Approximately 7 trillion dollars have been erased from stock market portfolios since the peak.

But, what about price deflation? According to the Cleveland Fed, the median Consumer Price Index was up 0.3% in July. So, we're not currently in any price deflation. But the Consumer Confidence Index fell 9 points in July to 97.1, so consumers aren't feeling too happy.

And even if price deflation comes anyways, what's wrong with that? Won't it be nice to see gasoline, food, and clothing with cheaper prices?

The problem with a major price deflation is that it can severely have a negative impact on the economy. The last time there was a major price deflation, it helped trigger the Great Depression of the 1930s.

When prices fall, that means demand is getting lower than the supply. It means that people aren't buying as much goodies. Perhaps they got laid off from their job. Perhaps there isn't as much loose change in the pocket for unnecessary expenditures. Perhaps they've hit their credit limits and can't get any more loans to buy stuff. Perhaps they're holding off to buy something since things will be cheaper in the future. Perhaps they are starting to think that saving is better then spending.

From the supply side, when demand is lower, companies react by producing less. So companies make less profits. As profits decrease (or losses increase), companies can lower wages or lower headcount to stay afloat. Or companies can also declare bankruptcy and all the employees and shareholders lose out. And as employees get a smaller paycheck or lose jobs and shareholders lose portfolio values, it perpetuates the deflation cycle.

Another thing about price deflation is that the Fed can't do anything about it. Well, they can inject more money into the system to counteract falling prices, but it can't solve the fundamental problems (job layoffs, lower wages, loss of consumer confidence) that causes price deflation.

The only thing the Fed can do is lower the fed funds rate (currently at 1.75) to get more people to borrow. But, if people have already bought their new car, their new house, and maxed out their credit cards, it won't matter how low the interest rate is. And companies don't typically invest for growth when sales are headed down. So companies won't borrow more either.

Will price deflation come? As long as the Fed is still around, it will continue to work the only magic it knows, to increase the money supply. So, barring a desolution of the Federal Reserve, we won't be seeing any major price deflation soon. But, more job layoffs, lower wages, more bankruptcies, and lower consumer confidence can most certainly come.

Fear of a free fall - US News
Double-Dipping Into Deflation? - Forbes
Bracing for Deflationary Pressure - The Street

Posted: 2002-08-26 15:36:41

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