Deflation

So, indulge me for a few minutes here as I break into a discussion of macroeconomics and current US economic policy.

Currently the Federal Reserve Bank is doing its best to encourage inflation. By keeping interest rates as low as they can possibly keep them they are trying to get consumers and businesses to spend money and crank up demand. The government has also pumped a lot of newly printed money into the economy which tends to lower the value of the dollar which when combined with the theoretical increase in demand created by artificially low interest rates should cause prices to rise, in other words, inflation.

Why would the Fed want to cause inflation? Simple, it is relatively easy to control inflation as you can simply raise interest rates and quell demand. So if something less than positive has to happen the Fed seems to think that inflation is the way to go, especially since the alternative, deflation, scares the guys at the Fed more than almost anything else in the world.

So let's talk about deflation for a second. Deflation is basically a way of saying that prices are falling, which of course sounds great. We all love getting a deal and walking into a store to find that everything is cheaper than it was the week before sounds like a pretty exciting prospect, especially when this happens during a bad economy and so many of us are watching our spending so closely.

This is where it gets tricky though, you see deflation is often times caused by a bad economy causing consumers and businesses to reduce their spending. As demand decreases manufactures reduce production and reduce their workforces, these layoffs cause an even greater reduction in demand which also leads to a reduction in prices to try and clear old merchandise off of stores shelves. This reduction in prices is of course, deflation. So prices start dropping, but they tend to drop in a rather gradual manner. Consumers knowing that prices are dropping can then enter something of a waiting game, patiently holding off on purchasing to see just how low the price might go. So even while prices are dropping consumers may still not spend at levels to raise demand to levels that would inspire companies to hire and even worse these same companies are making less money on each item sold and so they might even result to further layoffs to save money. This out of control downward trend is known as a "deflationary spiral" and there isn't much the Federal Reserve Bank can do to slow it down once it starts. Many believe the Great Depression can be explained as a deflationary spiral.

Add to this the fact that deflation hurts borrowers. When we enter a deflationary period we know that prices go down, this decrease in price is accompanied by an increase in the value of the dollar as each dollar can buy more. If you take out a loan with set monthly payments, of say $300.00, then as prices decline, but your loan payments remain the same, then you are actually paying more each month as your $300.00 has gone up in value.

Let's look at our current economic situation. Demand is low because of high unemployment and a slow economy. Savings rates are higher than they have been in years which reduces the amount of currency in circulation and would tend to increase the value of the dollar.  So it seems that we should be experiencing deflation right now. But we aren't.

Currently we are experiencing very low levels of inflation, barely over 1%, but prices are still rising when it seems that they should be dropping. Why is this? Well the Fed's effort to spur inflation is working, just not in the way it should. Instead of low interest rates increasing demand, which isn't happening to any great extent (banks are still rather hesitant to loan money and so the lower interest rates aren't allowing consumers and businesses to spend more) what they are doing is, however, having an effect on the value of the dollar on the international currency market. The dollar has been maintaining a fairly low value against other currencies because of the low interest rates set by the Fed, this means that the price of imported goods, which are much of what we buy these days, stays up and, in my opinion, is responsible for keeping us from entering a deflationary period.

But just as prices aren't dropping as we might have expected them to several decades ago before the manufacture and production of so many of the goods and items we purchase shifted to other countries so of the negative aspects of deflation might not occur as we would expect.

Lets say the Fed started promoting deflation instead of inflation. The first thing the Fed would do is raise interest rates. Currently I think this would have a very minor impact on demand in the US economy as banks won't be any less likely to loan money with high interest rates than they have been with low interest rates, in fact they might be willing to loan more cash as they would see higher possible profits once interest rates were raised. Raising interest rates would cause an increase in investor demand for US currency though as the value of our currency increased. This would cause money to be removed from circulation which would cause a further increase in the value of the dollar and a decrease in the prices consumers pay at the store.

If the value of the dollar increased quickly enough and prices fell fast enough I don't think we would see consumers waiting for even lower prices, especially if there is pent up demand that lower prices could tap into by overcoming consumer caution. We also wouldn't see major layoffs in the US as most of the manufacturing jobs negatively impacted by deflation have already moved out of the US and those jobs wouldn't be as negatively impacted because the reduction in the end prices paid by consumers would be offset by the increase in the value of the dollar being paid to these foreign manufacturers.

So we could see reduced prices, increased demand, and no real unemployment threat if we venture into deflationary territory. Yes, borrowers would still be negatively impacted, but the current economic situation is hurting them just as much. So please, if anyone reading this knows someone at the Fed tell them to reconsider their forecasting models, it seems they would have worked great 40 years ago, but they come up short in the global economy. Go Deflation!