Falling prices could bring a nasty hangover

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

Call it one of the recession's silver linings — with each passing day, the purchasing power of each consumer dollar is getting stronger.

But if it keeps up, and prices continue to fall, that boost in buying power comes with some nasty side effects, say economists.

The government reported Friday that consumer prices fell over the past 12 months at the fastest rate since Dwight D. Eisenhower was president.

Prices were flat in April after dropping 0.1 percent in March, leaving the Consumer Price Index 0.7 percent lower than it was a year ago, according to the Labor Department. That's the biggest 12-month decline since June 1955.

General deflation of any kind has not been seen in the United States since the 1950s, and benefits cash-strapped consumers looking for bargains and retirees trying to live on a fixed income.

Falling prices also help savers. If consumer prices are falling 1 percent a year, the real (price-adjusted) return on a bank CD paying 2 percent magically becomes 3 percent.

And falling prices are a terrific antidote to the stagnant wage growth that has weighed on many U.S. households since the last recession ended in 2001. Even if your boss freezes your wages, when prices are falling 2 percent a year, your real wage is rising 2 percent.

The flip side is that borrowers and consumers carrying heavy debt loads see their burden increase. As prices fall, the purchasing power of your dollars goes up, so your future monthly payments will take a bigger bite out of your spending power. That means if you’re paying 8 percent on a mortgage, and prices are falling 2 percent a year, your borrowing cost in real, price-adjusted terms is 10 percent.

Household borrowers are not the only ones who need to worry about falling prices. The threat of continued deflation is a thorny problem for businesses, and government policymakers including Federal Reserve Chairman Ben Bernanke. The risk is that the drop in prices begins to feed on itself. Lower prices take a big bite out of employers’ profits, which forces wage cuts or layoffs. That cuts consumer spending and demand, which brings more price cuts to spur sales.

“Once you get more downward pressure on wage and prices and it’s hard to get yourself out of that cycle,” said Brian Bethune, chief U.S. economist at IHS Global Insight.

Take the falling price of airline tickets, which have dropped for eight straight months — down another 1.5 percent in April, according to government data.

As the recession grinds on, consumers continue to postpone discretionary travel, further weakening demand. Business travel is also off sharply according to Mark Masuda, who manages airline partnerships with Travel Leaders, a Minneapolis-based travel company.  

“They’re putting the screws to their budgets and holding their travel and entertainment expenses down,” he said. “Once they get comfortable that consumers are coming back, they’re going to have to get out and see customers and find new customers and you’re going to see that travel increase as well."

Until then, the only way for airlines to fill planes is to cut fares.  If that keeps up, airlines can afford to lose only so much money before they make steeper cuts in their schedules, which means lower wages for their workers. As those workers spend less on other products and services, the lower demand forces wider cuts in prices.

Since the recession began over a year ago, changes in consumer prices have been uneven. While some categories have fallen, others continue to post gains, especially for goods and services where prices are regulated or changes take time to work their way through the system. Medicare reimbursements don’t fall if fewer patients show up for a given procedure. When bus ridership goes down, fares rarely follow. (Fares may even have to go up to make up for the revenue shortfall.) If an office building has lots of vacant space, most business tenants won’t get a break on their rent until their lease it up.

But there’s evidence that consumer prices are falling faster than the so-called “headline” consumer price index.

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