Data just released by the U.S. Labor Department show that inflation – ex energy and food – was flat in August. Core inflation has been running at an unusually low rate for several months. A review of comments and observations on this issue by a number of economists reflects a strong consensus that this trend will continue, perhaps dipping even lower.
This trend is one of the primary drivers behind the fears of a deflationary economy and double-dip recession in the U.S., and perhaps globally. Deflation is defined as a decrease in the general price level of goods and services, and occurs when the annual rate of inflation falls below zero percent. The inflation rate in the U.S. is trending troublingly close to zero.
As prices drop in a deflationary economy, consumers delay purchases and consumption in the expectation that prices will drop lower still. This actually does have the effect of driving prices lower (hence, the dreaded deflationary spiral), as vendors of goods and services lower prices in hopes of generating sales. To do this and maintain a profit margin, vendors must slow production and trim capacity. This results in a trickle-down effect of layoffs throughout the economy, stimulating a recession, which leads to further consumer conservatism. This essentially is what happened in Japan during its “Lost Decade”.
So, if deflation is bad, does that mean its opposite, inflation, is good? Yes and no. There is much disagreement as to what is a “healthy rate of inflation”. The pundits’ opinions vary in the 1% to 5% range, with 2% to 2.5% seemingly the norm. A healthy rate of inflation benefits productivity and wages, and encourages consumer activity.
Because the effect of inflation is to cheapen the currency, businesses and consumers aren’t reluctant to make long-term commitments. A two hundred thousand dollar home mortgage, for example, will be paid with cheaper and cheaper dollars over time in an inflationary environment. Inflation also has a market clearing effect in a situation such as the current one where deleveraging of underwater loans is greatly needed.
So, a little inflation is not such a bad thing after all. But, too much inflation is very bad. Unfortunately, the steroidal growth of the U.S. government and accompanying profligate spending by the current administration in Washington promises an inevitable surge in inflation – but it’s probably a couple of years away.
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