Falling prices raise worries about deflation

John W. Schoen Senior producer • Profile • E-mail

After years of punishing increases in the cost of energy, consumers are rejoicing these days at the sharp drop in prices at the pump. Not only that, but prices are dropping for clothing, transportation and housing, according to the government's latest report on consumer prices. With money tight, the price declines are a welcome relief.

But be careful what you wish for. If price declines continue and become more widespread, there’s a risk the downward trend could feed on itself in a spiral that can take on a ruinous momentum. It’s called deflation. And some economists are warning the threat is increasing.

“A benign decline in prices amidst a sluggish but recovering economy would be unwelcome but tolerable,” Merrill Lynch economist David Rosenberg wrote in a note to clients this week. “But the price slashing now under way as the consumer beats a hasty retreat could allow that corrosive deflationary spiral to take hold — something the Fed wants to avoid at all costs.”

Although the risk is still considered relatively small, concern about deflation is one reason stocks have been hammered this week, sending the broad Standard & Poor's 500 to its lowest close since 1997 Thursday. The rapid slowdown in the economy, coupled with the collapse of housing and financial markets, has increased the threat of a broad, sustained drop in prices.

While deflation might sound welcome, in fact it can be devastating to borrowers, banks and businesses. The Great Depression in the 1930s was accompanied by deflation of 10 percent per year, reflecting the widespread lack of demand.  Falling prices in the 1890s made it impossible for farmers to keep up with mortgage payments, as Fed Chairman Ben Bernanke noted in a 2002 speech on the topic.

As prices fall, consumers and businesses become less willing to spend and invest, worsening the economic downturn, as happened in Japan's "lost decade" of the 1990s.

A sustained drop in prices hurts in two ways. First, because consumers and businesses anticipate prices will continue to fall, they would likely cut back further on spending and investment. Why shell out $1,200 for that flat-panel TV today when you can get it for $800 six months from now?

As spending dries up, the economy starts to shrink; about two-thirds of the U.S. gross domestic product is based on consumer spending. As GDP shrinks, so do the companies providing those goods and services for consumers. As companies shrink or go out of business, unemployment rises. Out-of-work consumers have less money to spend, which cuts deeper into the economy. Once the cycle takes hold, it's very difficult to stop.

Deflation brings another, potentially bigger problem for an economy swollen with too much debt. Inflation is good news for anyone who owes money because, as prices rise, spending power is eroded and the real value of money declines. When inflation is rampant, you get to pay back the $1,000 you borrowed last year with dollars that are worth a little less each year.

That debtor advantage is turned upside down if deflation takes hold. As prices fall, the spending power of your money goes up. But so does the real value of your debt — because you have to pay it back with money that has increased in real value.

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