“Oh, no!” you’ve probably been thinking. “The cost of filling my gas tank dropped again!”
Falling prices are a good thing for the cash-strapped American consumer, whose income on-average has fallen to where it was in 1994, as we’ve reported. But behind every silver lining, there’s a black cloud and leave it to us to find it. 
Deflation is typically a sign that all is not well with the economy. Prices drop when the economy is so weak that consumer demand drops. When prices drop, profits decrease, stock prices drop, and unemployment and bankruptcies increase. Consumers put off purchases and wait for prices to fall further, which contributes to even further deflation. Deflation was an issue during the Great Depression and every period of deflation has been accompanied by a recession.
Raúl Ilargi Meijer of The Automatic Earth says deflation “eats societies alive,” explaining that “Deflation is not lower prices. Deflation is people not spending, then stores lowering their prices because nobody’s buying, then companies firing their employees, and then going broke. Rinse and repeat. Less spending leads to lower prices leads to more unemployment leads to less spending power.”
Very low inflation can also have a negative impact. As The Economist noted, “The most troubling effect of low inflation is on monetary policy. Central banks stimulate spending by reducing the real interest rate, which is the nominal interest rate minus the rate of inflation. This boosts investment and discourages saving, reducing the output gap. The real rate required to raise demand enough to balance investment and saving is called the equilibrium real rate. When demand is weak, the equilibrium real rate may be negative, and under low inflation it is difficult for a central bank to set a nominal rate that brings this about. And because nominal rates are in practice never less than zero (you can always just keep money in cash) deflation proper makes a negative real rate not just hard but arithmetically impossible: subtract a negative number (the inflation rate, in circumstances of deflation) from a number that has to be zero or higher and you always get something positive.”
Deflation does not appear to be a problem in America, except that in today’s global economy, what happens in the rest of the world affects us, too. And much of the world is in a fright over deflation of the Japanese variety, which resulted in the famous “lost decade” (that is quickly becoming the “lost two decades,” with scant signs of recovery in sight).
In the 34 OECD countries alone (that’s the Organisation for Economic Co-operation and Development), the number where deflation is a problem rose from four at the beginning of 2014 to 13 by the end of October. And that doesn’t include problem-child Japan, because its consumption tax boosted the inflation rate above 3%. (NOTE: If you’re trying to improve your economy, increasing taxes is not a good way to do it, even if it you need to boost your inflation rate.)
Countries with deflation issues include Greece (big surprise!), Estonia, Hungary, Portugal, Sweden, Israel, Poland, Slovenia, Italy, Spain, Belgium, the Slovak Republic and Switzerland. The inflation rate is less than 1% in the Czech Republic, Denmark, France, Germany, Ireland, Luxembourg and the Netherlands, and inflation is threatening to go below 1% in the United Kingdom.
Deflation in the U.S.?
So if a majority of OECD countries have a deflation problem – or likely will soon – why shouldn’t the U.S. be worried about deflation?
Keep in mind that, as we’ve pointed out, the U.S. inflation rate has been significantly higher than the rate reported as the Consumer Price Index (CPI), which excludes increases in the cost of food and energy. Yes, oil prices have been falling, but that’s a pretty recent phenomenon.
In spite of falling oil prices, the only people in America who are worried about deflation are members of the Federal Reserve Board, who have been trying to push inflation up to 2% for years without success.
That’s shocking, as the Fed’s actions were unprecedented. Yet, after $4 trillion in quantitative easing, the Fed has failed to achieve its goal of 2% inflation – the needle on the inflationometer barely budged.
Easy money policy creates inflation, because the greater the money supply, the less a dollar is worth. The dollar has been strengthening, though, since QE ended in October. With other countries turning to their own versions of QE in an attempt to ward off deflation, the dollar is likely to continue strengthening.
Like deflation itself, that’s good and bad.
With a stronger dollar, imports will cost less and American companies will likely need to drop their prices to remain competitive. You can travel to Europe now without taking a second mortgage on your home.
As baby boomers retire, they will likely spend less and that could also contribute to deflation, but the children of retiring boomers are now in the workforce and, in many cases, are earning more and spending more, which helps balance boomer retirement.
While deflation remains in check, American consumers are likely thinking, “Bring it on!” But falling oil prices are a good illustration of the good and bad sides of deflation.
Dropping oil prices were an early Christmas present, giving consumers more money for discretionary spending – which they, in turn, spent on Christmas presents. While Christmas season sales were far from overwhelming in 2014, results to date indicate that they “met expectations,” thanks to lower unemployment and lower gas prices.
Conversely, regions of the U.S. where hydraulic fracturing and horizontal drilling have created an economic boom will suffer because of lower oil prices, as the industry becomes a victim of its own success.
While the U.S. is expected to pass both Saudi Arabia and Russia this year to become the world’s largest producer of oil, there will be fall out. With the economy slowing down just about everywhere but in the U.S., the supply of oil is now well in excess of demand. Some companies cannot produce oil profitably at the new, lower prices, so they will go bankrupt or be sold, and projects that were in the planning stages will be shelved.
It’s like a “going out of business” sale – consumers benefit from lower prices, but the business and the jobs it represents are gone for good.
So falling oil prices will have a negative impact on some parts of the U.S., just as businesses that rely heavily on exporting will be affected by the strengthening dollar.
Then There’s Europe
So, as deflation spreads through Europe, political and economic leaders will likely see the need to do something about it. That “something” is likely to be some form of easy money policy, even though the European Central Bank has already pushed interest rates into negative territory.
This past week, according to Bloomberg, “European Central Bank President Mario Draghi gave his strongest signal yet that the European Central Bank is likely to start large-scale government-bond purchases by saying he can’t rule out deflation in the euro area.”
Among other things, QE in the Eurozone would make the euro weaker, which would make the dollar relatively stronger, which would further harm U.S. exporters and bring the U.S. closer to potential deflation, by lowering prices of imports even further.
To date, The Economist notes, “The ECB has put its hopes in targeted loans to banks, purchases of covered bonds that began on October 20th and purchases of asset-backed securities that are yet to start. Those efforts have yet to change the market’s psychology by much, in part because they will not significantly expand the ECB’s balance-sheet, which has been shrinking as banks pay off previous loans. Investors associate larger central-bank balance sheets with a greater commitment to lifting up inflation.
“If that doesn’t work, the ECB could directly buy corporate bonds. There is €1.1 trillion ($1.4 trillion) of non-financial corporate debt and €7.8 trillion of financial corporate debt outstanding. Buying up some of this debt would allow a significant expansion of the ECB’s balance-sheet. The next step would then be purchases of government bonds.”
In other words, quantitative easing. But, “If it didn’t work for the Fed, why should it work for the ECB?” That’s a question worth pondering.