On the road to deflation?

The last thing that the U.S. economy needs as it struggles to recover from its coronavirus-induced recession is a prolonged period of price deflation. A central question now facing U.S. policymakers is how likely is it that we will get deflation? 

Will the U.S. repeat the damaging debt-deflation experience of the 1930s? Or will it be spared deflation, as it was in 2008-2009 despite the very large gaps now characterizing the U.S. labor and output markets? 

There are several good reasons why a prolonged period of price deflation would be unwelcome. Among these is the risk that falling prices might induce both households and corporations to defer expenditures in the expectation of lower prices in the future. This was one of the key factors that impeded Japan’s economic recovery during its lost decade in the 1990s. 

Another reason why price deflation would be unwelcome is that it would make it all the more difficult for households and companies to service their debt. By reducing household and corporate income in dollar terms, deflation would increase the real debt burden. That in turn might induce both households and companies to cut back on their expenditures in a manner that could lead to a 1930s-style debt-deflation spiral.

Yet another reason to fear price deflation is that it would reduce the efficacy of monetary policy. In trying to jumpstart the economy, the Federal Reserve tries to reduce interest rates to below the inflation rate in order to encourage both consumption and investment. But with interest rates already at or close to their zero-bound, deflation makes that very difficult to achieve. This is particularly the case when one considers that other central banks have found that there are clear costs and limits to the use of negative interest rates. 

During the 2008-2009 Great Recession, when U.S. output fell by 5 percent and unemployment rose to a peak of 10 percent, the U.S. experienced only a very limited period of falling prices. The reason for this surprising absence of deflation was that inflation-expectations were well anchored. The general expectation then was that very aggressive monetary policy action by the Federal Reserve would ensure that it would meet its inflation target. That in turn caused economic agents in general to refrain from cutting prices and wages.

The deflationary experience during the 1930s Great Depression was very different from that in 2008-2009. Indeed, in each year between 1929 and 1932 U.S. prices fell by around 10 percent. In part, this owed to the fact that output declined by more than 25 percent during that Depression and unemployment rose to a peak of 24 percent in 1932.  However, it also reflected the egregious mistake made by the Federal Reserve to allow the money supply to fall, which contributed to a wave of economically damaging bank failures.  

It remains to be seen what our inflation experience will be in the age of the coronavirus pandemic. The optimistic view is that we will be spared deflation as a result of the Federal Reserve’s very much bolder and swifter policy response to this economic crisis than was the case in 2008-2009. Maybe that will be enough to keep inflation-expectations well anchored and to spare us from a 1930s style debt-deflation experience. 

The pessimistic view is that our current crisis resembles the Great Depression more than the 2008-2009 recession. For a start, this time around unemployment is expected to hit a high of well over 20 percent, which would be more than twice the 10 percent peak unemployment rate seen in 2009. Similarly, the decline in the U.S. economy this time around is expected to be roughly twice that in the 2008-2009 recession.

In addition to downward price pressure from the larger labor and output market gaps today than in 2008-2009, other special factors could also lead us towards price deflation. These include the dollar’s strength and the recent collapse in international commodity prices in general and in oil prices in particular. They also include the likely decimation of particular sectors of the economy – like the travel, hospitality and restaurant sectors –  increased bankruptcies, and the trend towards working at home, which all might lead to considerable downward pressure on a broad swathe of prices and rents. 

In navigating unchartered waters, it would be a mistake for U.S. economic policymakers to dismiss the deflation risk out of hand. Rather, in the months immediately ahead, they would be well advised to carefully monitor price and wage developments and be prepared to respond quickly and boldly to evidence that the U.S. economy might once again be succumbing to another prolonged period of price deflation.  

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.