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Deflation: Why the Fed—and Investors—Fear It

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January 6, 2015

At first glance, the whole idea sounds pretty enticing—falling prices for almost everything you need and want.

But make no mistake, deflation—a macroeconomic condition involving generally declining prices—isn’t really a good thing. It can suck the life out of an economy, causing all kinds of pain for businesses and consumers: sinking wages, weaker employment and output, eroding confidence. Just ask Japan—it’s spent the better part of the past two decades trying to climb out of a deflationary pit.

For U.S. investors, deflation isn’t a major concern at the moment, at least not at home. But considering the economic struggles in Japan and Europe, it’s worth understanding what deflation is, its effects, and why our central bank—the Federal Reserve—keeps a close eye out for it.

Why the Fed Fears It

Deflation is actually a symptom of bigger problems. Former Fed Chairman Ben Bernanke, in a 2002 speech, said the sources of deflation “are not a mystery. Deflation is in almost all cases a side effect of a collapse of aggregate demand—a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers.”

For investors, deflation is not pretty. Equity prices erode as people sell off assets that aren’t generating decent returns. Other assets, such as real estate, also suffer. If the U.S. were to shift from 2% inflation to 2% deflation, annual Gross Domestic Product would plunge by about 13%, or $2.28 trillion, according to research from the Boston Fed. That would be approximately the magnitude of four Great Recessions. Ouch.

A Vicious Cycle

Deflation causes major headaches for central bankers. Consumers in a deflationary economy aren’t seeing wages increase (assuming they have jobs) and often hold off on purchases, knowing prices will go even lower. This creates a vicious cycle that’s very difficult to reverse.

Lowering short-term lending rates to stimulate demand is a primary tool for the Fed and other central banks. But you can only cut rates so much. Benchmark rates in the U.S. have been near zero for over six years, yet economic growth has, until recent months, remained relatively tepid. And as Japan has shown, central banks eventually run out of bullets. Investors find themselves stuck with unproven and costly forms of stimulus, which end up distorting the natural mechanics of the financial system.

What the Fed Watches

The U.S. financial system is built to accommodate, if not encourage, rising prices, and a lot of moving parts are built around that assumption. The financial media tends to focus on current inflation readings such as the Consumer Price Index (CPI). But there’s also “expected” inflation, which is among the dynamics the Fed tracks.

Expected inflation, similar to actual inflation, has run around 2% to 3% annually. The Fed watches a Forward Inflation Expectation rate, which reflects what investors and other market participants believe inflation will be about five years into the future. Since the recent Great Recession, the Fed has initiated various rounds of quantitative easing (QE) stimulus, partly in response to signs inflation expectations were dropping (see figure 1).

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FIGURE 1: PRICING POWER.

Since the 2008–09 recession, the Fed’s QE stimulus efforts often coincided with declining expectations for inflation. Source: St. Louis Federal Reserve. For illustrative purposes only.

In the U.S., we’ve seen inflation remain tame for several years at slightly under 2% (based on the CPI), and we appear to be on a similar track for 2015. That’s good for consumers and investors in many ways (like when you’re filling up your gas tank). But if you find yourself tempted to gripe about higher prices for food, movies, or anything else, remember—we could have it much worse.