The growing threat of deflation

A widespread drop in prices might seem like a good thing to most consumers, but the Fed and economists see it as another reason to worry.

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By Chris Isidore, CNNMoney.com senior writer

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NEW YORK (CNNMoney.com) -- Lower prices are probably at the bottom of the list of most Americans' current economic worries. But for a growing number of economists, it's their biggest fear.

A widespread drop in prices is known as deflation. And typically, it's not just the price of consumer goods that fall. Home prices, stock prices and even people's salaries often head lower as well.

The biggest problem with deflation is that when businesses need to continually cut prices to spur sales, they eventually respond by cutting production. That results in growing job losses, and could, in the worst case scenario, even cause a depression.

And several economists say they are far more worried about the threat of deflation now than they have been in the past. The Federal Reserve may also be more concerned about deflation as well.

The central bank cut its key interest rates to near 0% Tuesday. In its statement, the Fed said it expects inflation to "moderate further" but it stopped short of suggesting that inflation would drop "to levels consistent with price stability" as it has in prior statements.

"I think the Fed's statement clearly reflected some alarm that there is a greater risk of not just deflation, but of depression," said Bernard Baumohl, executive director of The Economic Outlook Group, a Princeton, N.J., research firm.

Just a month ago Baumohl put the chance of a deflation at between 10% to 20% sometime in 2009. Now he believes there's a 30% chance of deflation.

Drops in consumer prices

Economists have reason to fear that a deflationary spiral is looming.

On Tuesday, the government reported that its Consumer Price Index -- a key gauge of inflation -- fell a record 1.7% in November. Over the past three months, retail prices have plunged at a 10% annual rate.

While much of that drop was caused by falling gasoline prices, the so-called core CPI, which strips out volatile food and energy prices, declined by 0.1% in November, the first decline in that reading since the severe recession of 1982.

Core consumer prices are now up only 0.4% on an annual basis over the past three months. That is below the 1% to 2% annual range that is generally believed to be the Fed's comfort zone for inflation.

It doesn't take much of a price decline to cause economic pain. During Japan's so-called "lost decade" that started in the 1990s, prices only fell by 1% annually. But those deflationary pressures resulted in a prolonged recession.

So far, few economists believe that a couple of months of price declines is enough evidence to suggest that the U.S. is now going through a period of deflation.

But economists think the Fed should try and nip deflation in the bud and that was probably the reason why the central bank cut interest rates by more than expected.

"They're not dismissing [deflation] the way they did in the past," said David Wyss, chief economist for Standard & Poor's.

Economists debate threat

Wyss said he doesn't believe that deflation is likely to take hold in the next year. But he cautions that if the current recession continues into 2010, "the risk is significant."

Of course, not all economists are voicing increased fears about deflation.

A senior Fed official told reporters on a conference call Tuesday that deflation is not now a major worry, but conceded that the central bank would continue to closely monitor prices to make sure it doesn't become a problem.

Rich Yamarone, director of economic research at Argus Research, said his firm's deflation index is showing less of a deflation threat today than it did in 1998 or 2002-2003, the last time many economists were fearing deflation.

Yamarone said the deflation fears proved overblown in those periods, and he's confident the threat of falling prices won't play out again this time.

"We believe that the market, the Fed and the business press are all going to get it wrong this time around as well," he said. He said the drop in commodity prices, particularly oil, has caused what will prove to be a temporary fall in other prices.

Bernanke's deflation views

Whether or not Yamarone is right may depend on how the Fed continues to respond to this economic crisis.

Fed Chairman Ben Bernanke has spoken frequently in the past about deflation and how he thinks it was a significant factor in the Great Depression, his area of expertise when he was an economics professor at Princeton University.

In November 2002, Bernanke, then a Fed governor, gave a speech about how to combat inflation. That speech may offer some hints as to how the Fed may fight deflation if it becomes more of a threat.

Bernanke became known in some circles as "Helicopter Ben" for his facetious suggestion in that speech that even if the Fed cut interest rates to zero, it could continue to battle deflation by other measures, including dropping large wads of cash from helicopters.

The speech clearly signaled that Bernanke was less scared of cutting rates to zero than he was by the threat of deflation, which he described in terms that appear prescient today.

"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," he said at that time.

He said deflation would then lead to recession, rising unemployment and financial stress. And he added that while "deflation in the United States is highly unlikely, I would be imprudent to rule out the possibility altogether."

He argued that the Fed and Congress could take steps beyond cutting rates to ward off serious deflation. And he expressed confidence such measures would work, as long as they were taken before deflation took hold.

"Prevention of deflation remains preferable to having to cure it," he said in the speech.

And in his concluding remarks, he added that "the Federal Reserve and other economic policymakers would be far from helpless in the face of deflation, even should the federal funds rate hit...zero." To top of page

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