The spectre of deflation

Price stability provides the ideal environment for households and businesses to make decisions that lead to the smooth functioning of the economy.

Rising prices or falling prices (at an aggregate level) distort the relative price mechanism so crucial for the resource allocation in the economy. Greenspan recently stated in his economic outlook "the probability of an unwelcome substantial fall in inflation over the next few quarters, though minor, exceeds that of a pick up in inflation".

This article tries to place deflation in historical context, understand the potential indicators of deflation, explore the possibility of deflation in the US and finally evaluate the implications for the world economy in general and India in particular.

Deflation is defined as a generalised decline in the aggregate price level measured by some price index such as consumer price index. Deflation is usually the symptom of underlying weak demand and/or excess supply. It becomes a serious problem when it becomes entrenched in expectations.

For example consumers will defer purchase decisions expecting a decline in prices. Businesses will delay investment decisions as the lack of pricing power signals low profitability. Such developments can lead to a vicious cycle as the slowdown in consumption and business investment can lead to further decline in demand leading to falling prices and a dangerous deflationary spiral sets in.

Attempts to jump-start the economy by lowering interest rates also does not work. There is a zero bound for nominal rates and even at that level if, for example, deflation is at 2 per cent, real interest rate will be 2 per cent. Unorthodox monetary policy measures can be embarked upon.

Also there is downward rigidity in nominal wages. While it is common to expect nominal wages to increase with inflation to protect real wages, the reverse is true for deflation. Nominal wages will have to fall to maintain stable real wages.

Clearly dealing with deflation takes us into unchartered territory not seen in the post-war period. However the later part of the 19th century and early part of the 20th century experienced periods of general price decline.

During the gold standard period and the interwar period, there were a high proportion of years in which there was deflation. In stark contrast in the post-war period, excluding Japan, the other G-7 countries have barely had any deflation.

During the gold standard era, deflation was associated with positive supply shocks: technological progress. The world economy grew by 2.11 per cent during that period.  The interwar period, the US experienced prolonged period of decline in prices.

The stock market crash in 1929 was exacerbated by US Fed restrictive monetary policy, which prolonged the deflation and led to the great depression. Deflation resulting from lack of demand leads to significant economic distress.

A recent IMF report emphasises four sets of indicators to assess the vulnerability to deflation.  The broad indicators are aggregate prices, measures of excess capacity or output gap, asset markets and credit market and monetary indicators.

Inflation statistics suffers from measurement problems and possible upward bias. The price indicators reflecting a low value of inflation of less than 0.5 per cent are certainly something to worry about.

Excess capacity can act as a drag on growth. The world economy grew below average in 2001, again in 2002 and most probably even in 2003. The implication is that globally there is excess capacity, which will lead to decline in prices.

The asset market indicators focus on equity market and housing market. The bursting of the equity bubble has weakened household and corporate balance sheets but the increases in house prices has offset some of the adverse consequences.

The credit and money indicators deal with evaluating if credit growth is keeping pace with nominal GDP growth, risk aversion may indicate the role of credit and money channels in creating deflationary pressures.

The world is dependent on the US for growth. The explicit statements by Fed officials that there is a higher probability of deflation than inflation going forward, is a clear and present danger for the prospects of world economic growth.

Some of the indicators pointing in that direction are: low capacity utilisation, sluggish business investment and moderately high-risk aversion in the US.

The levels of capacity utilisation today are close to the level seen during the last recession in 1991.  Since reaching the peak in mid-2000 of 83.6, it has been on a steady decline and is currently hovering around 74.4.  Given the average productivity growth in the 1990s was close to 2.5 per cent and labour force growth of approximately 1 per cent, potential output must grow at 3.5 per cent every year. 

Persistent shortfall of actual output in comparison to potential output sets the stage for deflation.

One of the hopes of that the US economy will get back to the glorious 1990s is through a recovery in investment spending. Traditional investment models focus on growth rate of output and user cost of capital as drivers of investment.

The recent slowdown in the US is unique in the sense it was an investment-led slowdown. Approximately 55 per cent of the total real spending on US capital equipment is due to information technology. The boom years of the 1990s led business managers to invest with unrealistic expectations of future profits that were validated by stock market analysts.

The reality check has forced business managers to maximise their return on existing investments and scout for low cost outsourcing options worldwide. Prof Bernanke (member of the board of governors) in his recent speech in New York referred to the important role that will have to be played by high tech equipment and software in reviving investment spending.

However this category is also very sensitive to management beliefs and expectations. The global outsourcing model is ramping up and serves as a countervailing force for any pick up in tech spending.

The yield difference between  Moody's Aaa ( investment grade  --  highest quality) and Moody's Baa ( investment grade  --  adequate payment capacity ), one of the measures of risk aversion, is still high. Though there has been some reduction compared to mid-2002, risk aversion is still uncomfortably high.

The recent rally in the US equity markets overlooks the underlying weakness and will soon adjust to reality. The US tax cut will not jump start growth as it gives too little upfront and more on a multi-year basis.

Japan is suffering from mild but persistent deflation, Germany is on the slippery slope toward deflation. The strength of the euro can bring deflation to Europe and given its structural rigidities, will depress growth. The world economy is dangerously out of balance, with significant risk of deflation.

Policymakers in India should realise that the global economic conditions signal sustained weak external demand. Hopefully with a good monsoon and policies to spur domestic demand such as incentives for housing, infrastructure projects, India can wade through this period of global uncertainty by harnessing domestic sources of growth.