By Jill Schlesinger
Tribune Content Agency
Since the Great Recession, the Federal Reserve has worked hard to boost the economy. Part of the Fed's mission was to keep core inflation (the price of goods and services excluding food and energy) at a pace of two percent annually.
Although there have been instances over the past six years when either energy or food prices jumped, temporarily raising the specter of inflation, throughout the financial crisis and the recovery, the central bank has been much more focused on deflation, which is defined as a drop in the price of goods and services.
For those who were around during the inflationary 1970s and 1980s, deflation is an alien concept. But according to the government, the near-60 percent plunge in oil prices pushed down consumer prices by 0.4 percent in December from the previous month, leaving the CPI just 1.6 percent above where it stood a year ago, below the 1.9 percent annual rate over the past 10 years.
Although the idea of falling prices seems like a good thing, when deflation is persistent, it can put into a motion a scary, downward spiral. It starts when the economy cools, which prompts companies to reduce prices in the hopes of luring customers and maintaining sales volume. But as companies make less money, they could then cut jobs and/or wages, which could then cause consumers to spend less in order to service their fixed costs, like taxes and mortgages/rents.
The longer that deflation goes on, the higher the risk that consumers and businesses become accustomed to the situation and delay spending, hoping they'll eventually be able to buy goods more cheaply and to invest more efficiently. They also become less willing to borrow.
The vicious deflationary cycle can mire an economy in a deep recession or even worse, a depression. As an example, between 1929 and 1933, U.S. consumer prices fell by a cumulative 25 percent. More recently, Japanese consumer prices have been stuck for the past 20 years and the Euro Zone and the United Kingdom are both currently battling falling prices.
Besides the obvious harm that deflation can cause, the other problem is that central bankers have limited tools to fight it. (In contrast, when there is inflation, hiking interest rates may hurt in the short-term, but it is effective in combating higher prices.) In a deflationary environment, policy makers would likely return to bond buying (Quantitative Easing), which depending on the magnitude of price declines, may not stop the downward spiral.
By now you understand that deflation is a problem. Today, the big question is whether the current drop in prices is temporary or whether there is something scary brewing. Analysts at Capital Economics believe the odds are that while negative readings on headline inflation could persist at least for the first half of the year, "it is hard to see why this renewed slump in oil prices, which is developing against a backdrop of a rapidly improving real U.S. economy, will lead to anything more than a temporary drop in inflation." They are quick to point out that even when crude oil collapsed from a 2008 peak of $140 per barrel to $40, amid a deep recession, prices recovered and the economy avoided a prolonged bout of deflation.
That said, they also add that "Deflation may be just one recession away," which is probably why Fed officials continue to err on the side of adding more stimulus to the economy rather than less, and are taking a "wait and see" attitude toward increasing short-term interest rates. Currently, the consensus is for the first rate hike to occur in the third quarter of this year. But any indication of an economic slowdown, accompanied by a more substantial drop in core prices, could put the Fed on hold longer, to avoid a dangerous deflationary downward spiral.
Jill Schlesinger, CFP, is the Emmy-nominated CBS News Business Analyst. A former options trader and CIO of an investment advisory firm, Jill covers the economy, markets, investing and anything else with a dollar sign on TV, radio (including her nationally syndicated radio show), the web and her blog, "Jill on Money." She welcomes comments and questions at firstname.lastname@example.org. Check her website at www.jillonmoney.com.
This was printed in the February 8, 2015 - February 22, 2015 edition.