ECONOMY
Deflation
Falling prices can wreak economic havoc
Last Updated: Thursday, November 20, 2008 | 3:19 PM ET
By Philip Demont CBC News
All of a sudden, the financial press and airwaves are full of talk about a looming bout of deflation facing the United States.
This 'd'-word is defined as a generalized reduction in the country's price level.
But, if a rising price level, or inflation, is usually seen as a bad thing for economy, it stands to reason that falling prices would be an economic winner, doesn't it?
Not so fast.
Even as the possibility of tumbling prices rears its head, the reasons underlying the drop will tell the tale. Unlike rising prices, why you have deflation determines whether you want it.
Why do people care about deflation now?
The October report of the U.S. producer price index (PPI) — a measure of what manufacturers get for their goods — posted a record drop of 2.8 per cent compared to September. Worse still, the PPI was down 15 per cent for the August-to-September period of 2008 compared to the same period last year.
For many economists, the U.S. economy has obviously entered a period of disinflation, when price increases ease, and not so obviously might be entering a time of deflation, a much more worrisome prospect.
Why worrisome?
Again, it all depends upon the rationale for the deflation.
If prices are dropping because companies are more efficient at making products, the economy is better off.
Computer prices, for example, have dropped substantially in the past two decades. In the United Kingdom, hardware costs fell by more than 50 per cent by April 2001 compared to six years earlier.
When a firm cuts its sticker price because it can build its widgets better, the entire economy wins, both companies and consumers.
That decidedly is not the case during the current financial crisis.
Here, demand for goods and services is evaporating.
In the United States, consumer demand slid in October, off 0.3 per cent with November and December expected to be equally bad.
As well, any interest in buying new or existing homes has dried up. And retail experts now anticipate a round of price cuts as stores and manufacturers try to move mountains of merchandise from the backroom and the factory floor.
Then, isn't deflation a good thing?
Nope.
In the current economic climate, deflation hurts employment prospects and individual savings.
Start with jobs.
Suppose a company has to reduce prices to get rid of product. With less cash coming into its treasury, the firm now needs to chop payroll costs to maintain profitability or at least cut potential red ink.
To adjust their wage bills, firms in industrialized countries usually fire employees rather than cut their wages.
North American industry, plagued by falling demand and job reductions, might be an extreme example of what can happen in a deflationary time.
For the economy as a whole, most economists expect the unemployment rate to start rising.
The U.S. Federal Reserve Board now predicts the American jobless rate will crack seven per cent in 2009. Back in the summer, the U.S. central bank thought the 2009 unemployment rate would be approximately 5.5 per cent.
Next, look at savings.
In a deflationary world, governments usually cut interest rates to try to spur demand. As a result, what you receive on your savings account, already pretty low, will head toward zero.
Putting your money in fixed income financial instruments, such as government bonds, can provide some relief. The coupon rate on those pieces of paper will drop as Ottawa cuts borrowing costs. But, the price of the underlying bond will tend to rise with falling interest rates.
Equity markets, however, do not provide any financial shelter. That is because those same companies cutting prices will be posting lower profits, shopping their value as an investment.
Finally, many people have a large portion of their personal financial net worth tied up in their home, an asset that has appreciated more than 60 per cent in Canada between 1997 and 2007.
Unfortunately, for potential sellers, once-interested buyers are now too concerned about keeping their jobs or maintaining their own savings to venture into the resale or new homes markets.
Thus, people looking to cash out of their homes might find themselves in a panic market where any bid is accepted on the assumption that the next one will be for a lower price.
Does anybody benefit by deflation?
Very few, it would appear.
Businesses or people with cash in the bank could gain because they could pick up assets, whether commercial buildings or cars off the lot, for a fraction of their former cost.
Unfortunately, the recent bout of lower interest rates gave individuals and companies an incentive to borrow cash. Thus, even the well-off in the current economic environment probably have few liquid reserves to go on a buying spree.
Theoretically, lenders are better off during a period of deflation since they will be repaid in dollars whose purchasing power has increased since the time of the initial loan.
The problem here is that borrowers also have a bigger incentive to declare bankruptcy or otherwise walk away from the loans.
What can governments do to help?
Deflationary cycles can be self-reinforcing.
Potential buyers tend to hold off purchases if they believe prices will drop further. Sellers then have to cut their asking prices to get people or companies in the door. And, of course, the price reduction only encourages potential purchasers to wait even longer.
In that scenario, governments often cut interest rates to lower borrowing costs and encourage spending.
Companies, however, might ignore such incentives if they believe demand for their products is falling. After all, a loan for a plant is not of much value if no one wants the factory's output.
The U.S. economy found itself in this type of a liquidity trap during the Great Depression of the 1930s. At that time, falling interest rates failed to boost economic activity since new demand was non-existent.
That leaves the old government standby, fiscal stimulus. Basically, the government could spend borrowed cash on new bridges and other infrastructure projects or on hiring the unemployed.
That policy, however, could lead to government deficits and might be blunted by unfavorable exchange rate moves and other economic factors.
What about inflation?
At its most basic, inflation simply refers to the upward price movement of goods and services — in other words, the rise in the cost of living. The rate at which prices move up is one of the most closely watched economic indicators. When prices rise, the purchasing power of money drops. The expectation that prices will continue to rise leads to workers demanding more pay to prevent themselves from falling behind.
What causes inflation?
It depends on which economist you ask. Some argue there's a strong link between inflation and the supply of money. If the amount of money in circulation rises, so will prices. Others point to an overall demand in the economy: if demand for products exceeds the capacity of factories to build them, prices will rise. Prices fall if fewer and fewer people want to buy those products.
How is inflation measured in Canada?
Statistics Canada tracks inflation through the Consumer Price Index (CPI), a basket of about 600 goods and services the average Canadian household consumes. Most prices are checked during monthly visits to major retailers. Other prices are checked by phone or on the internet. Nationally, about 650,000 prices are checked each year.
Prices are weighted by their importance in the total budget, so a 10 per cent increase in rent would have a bigger impact on the CPI than a similar increase in bread.
The CPI is measured against a base year, which is currently 2002. So, if Statistics Canada reports that the "all-items" CPI hit 115.3, it means that it now takes $115.30 to pay for a typical basket of goods and services that cost $100 in 2002.
What is the rate of inflation?
It's the number we pay the most attention to. When Statistics Canada reports that the annual rate of inflation was 2.1 per cent one month, it means that its representative basket of goods and services costs 2.1 per cent more than it did a year earlier. If the following month's rate of inflation is lower, it does not mean prices fell. It just means a slowing in the rate at which prices increased.
What is the core rate of inflation?
The core rate of inflation measures price changes in that same basket of goods — but without the most volatile elements (fruit, vegetables, gasoline, fuel oil, natural gas, mortgage interest, intercity transportation and tobacco products). It's the rate the Bank of Canada takes most note of.
Since 1991, the central bank and the federal government have set inflation targets. The Bank of Canada currently tries to keep the rate of inflation between one and three per cent and aims for a two per cent target midpoint. The central bank uses interest rates to try to keep the rate within its target. When inflation is at the low end of that band, the bank has the freedom to cut interest rates. However, if the inflation rate starts heading toward the upper end of the target, the bank may raise interest rates.
Higher interest rates tend to reduce demand for certain goods and services. For instance, you'll be less likely to buy a car or a house when rates are higher and it's more expensive to borrow to finance the purchase.
What else has been used to try to control inflation?
In 1975, the government of Prime Minister Pierre Trudeau set up the Anti-inflation Board (AIB) in its efforts to combat inflation. The government introduced wage and price controls, which were administered by the AIB.
It was the first time that the government used wage and price controls in peacetime. The wage and price controls applied to the public sector and to private companies with 500 or more employees. Wage increases were capped at 10 per cent in the first year of the anti-inflation program, eight per cent in the second year, and six per cent in the third year.
The program was very good at keeping a lid on wage increases. But by the early 1980s, inflation had hit 12.5 per cent.
What is stagflation?
With stagflation, prices are rising even while the economy is stagnating. In North America, this last happened in the late 1970s. Rising oil prices hit the economy hard — forcing up prices for many goods and services even as people were losing their jobs. Purchasing power in North America fell as wealth was transferred from oil-consuming countries to oil-producing countries.
What is hyperinflation?
Pretty much the worst of all worlds. Most economists describe hyperinflation as "an inflationary cycle without any tendency toward equilibrium." It's a vicious circle of constantly — and rapidly — rising prices. Many factors can lead to hyperinflation, but the direct cause is an unchecked increase in the money supply.
Some governments have occasionally resorted to printing more and more money to meet their expenses. This increase in the supply of currency without any matching increase in demand leads to a drop in the value of the currency. Extreme examples of hyperinflation include:
- Germany in the early 1920s, when the rate of inflation hit 3.25 million per cent per month.
- Greece in the mid-1940s with 8.55 billion per cent per month.
- Hungary mid-1940s at 4.19 quintillion per cent per month.
By late 1923, the Weimar Republic of Germany was issuing 50-million-mark banknotes. The National Bank of Yugoslavia issued the largest banknote ever in 1993: 500 billion dinars. Zimbabwe currently has the world's highest inflation rate, at 165,000 per cent as of February 2008.
