[Pen-l] deflation?

["Jim Devine" <jdevine03@xxxxxxxxx>]

Some people in the media are freaking out about the possibility of
steadily and/or steeply falling prices, i.e., deflation. So I figured
out what kind of deflation was currently being expected by those in
financial markets.

I calculated the expected inflation rate implied by the difference
between the rates on constant-maturity non-indexed 5-year government
bonds and the inflation-indexed version of the same bonds. This number
was steady at between 2 and 3 percent per year from 2003 to early July
of 2008, which in general fits with the inflationary experience of the
time. Then, there was a sudden fall. (What happened on July 2? or
thereabouts?) As of November 20, it was –1.79%!! It's not just the
media. The finance types are also freaking out.

Why is deflation a bad thing? Part of it is if people expect prices to
fall, they delay purchases. Also, if prices are falling steadily,
people don't want to borrow because the real value of their debts
would rise. It's the opposite of the case of the inflationary 1970s,
when people wanted to borrow a lot because the debts would lose value
over time.

In looking at loans economists use the "real" interest rate, which is
the nominal or money interest rate minus the expected inflation rate.
Suppose I pay 4% interest on a loan. At the same time, inflation is
barreling along at 2% per year and I expect it to do so in the future.
That means the money I'm paying my loans back is losing 2 percent of
its purchasing power each year. Thus, I subtract the inflation rate
(2%) from the nominal rate (4%) to get the real rate, the interest
rate in constant purchasing-power money (2%).

If the inflation rate that people expect goes from 2% per year to -2%
and the interest rates appearing on loan agreements stays put at 4%,
the real interest rate rises from 2% to 6%. And it's this rate that
counts in determining decisions.  The nominal rate can fall, of
course, counteracting this. But it can't fall below 0. After that,
increasing rates of deflation mean rising real rates.

Rising real rates make the recession worse by discouraging borrowing
and spending. Recession then encourages further deflation. It can be a
vicious circle.

It's more than a matter of expectations. If people are locked into
long-term loans with constant nominal interest rates and amortization
rates on principal, and if nominal wages and salaries generally fall
with prices, that means that debt service rises relative to wages due
to deflation. If general enough, this phenomenon encourages
bankruptcy.

Key to the last paragraph is the assumption that nominal wages and
salaries fall with prices. A "true" deflation can be distinguished
from a minor one by saying that in a true one, we see a wage/price
spiral going downward. If wages and salaries don't fall as quickly as
prices, on the other hand, a mild deflation causes profit squeezes.
Both are unpleasant in a capitalist economy.
-- 
Jim Devine /  "Nobody told me there'd be days like these / Strange
days indeed -- most peculiar, mama." -- JL.
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