Deflation Revisited
September 14, 2002

America is on the cusp of deflation, a broad-based decline in prices. For decades, the term "deflation" has been relegated to the remote backwaters of economic history and fringe rantings about a coming economic Armageddon. No more.

The numbers paint the trend. Major newspapers around the world published some 2,400 stories about the risk of deflation over the past five years. That's three times the comparable figure during the previous five years. Retail prices for everything but autos are down 2 percent from a year ago. That has to be one of the biggest price declines for such a broad category since the Great Depression. The gross domestic price deflator, a broad gauge of inflation, hovers at 1 percent—a four-decade low. Japan, the world's second-largest industrial economy and a major trading partner, is in deflation.

Deflation can be malicious. The traditional levers of monetary policy are less effective when prices are falling. The cost of paying off debt increases. Corporate profits dissipate as consumers hold off on major purchases, knowing that they'll get a cheaper price by waiting just a few more weeks or months. Managements desperately struggle to conserve cash by laying off workers and delaying investments. All this has happened in Japan.

The worry on Wall Street and in Washington is that the United States could follow Japan into a downward deflationary spiral. The U.S. economy is fragile from the nasty aftershocks of 9/11 and the NASDAQ implosion. America's chief executive officers complain that they can't hike prices, forcing them to shore up profit margins by avoiding risky endeavors, such as hiring workers and making major investments. The price spiral toward near-deflation is the primary reason for the anemic stock market.

Still, the parallels between Japan and the United States are overblown. America's speculative excesses in the late '90s pale next to Japan's. Dot-com stock prices reached stratospheric heights. But at one point the land beneath the Imperial Palace in Tokyo was estimated to be worth more than all of California! Economic growth has averaged 3 percent so far this year, and productivity growth a stunning 5 percent. Even corporate profits are up over a year ago. Fiscal policy is simulative, and the Fed can cut its benchmark interest rate by several more quarter points before hitting zero.

That said, the emergence of deflation marks a major turning point. The price level is likely to remain unchanged for the next decade or so, after averaging out short cycles of inflation and deflation. Consumers, investors, managers, and policymakers will all have to adjust to a world where prices are just as likely to go down as up.

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