Deflation - Should we be Afraid of it?

Out of all the financial terms being tossed around these days, one of the least understood is deflation.

Most people have at least a basic understanding of inflation and how it affects them. But what is deflation? And what affect does it have on the market and individuals?

In simplistic terms, deflation is when prices drop. Deflation can also be defined as negative inflation. It doesn’t sound too bad, does it?

Well, it can be. According to a recent Fox News article, deflation is actually worse for the economy than inflation. Why? Because deflation causes prices to drop in certain markets, not just in the entire marketplace.

Take the housing market, for instance. Buyers disappeared as lending dried up and house prices took a dive. For some buyers, that sounds like a good thing: buying the home they want at a really great price. However, many buyers look at the falling prices and hold off in hopes of even lower prices.

This can cause a spiral effect, much like spiralling inflation (remember paying $4-$5 per gallon for gas not long ago?), which is a really bad thing for the economy. Let’s break deflation down a bit further:

• Consumers cut spending as lending evaporates
• Companies slow production and cut jobs as consumers spend less
• Consumers spend even less as employment fears take hold

This pattern can continually repeat until an eventual depression hits. But deflation is rare in the U.S. The United States has not experienced a true deflationary period in about 60 years. There have been times of what is known as “disinflation,” or an inflationary slowdown, but not actual deflation.

What does deflation mean to the average person? Well, it could mean anything from losing your job to seeing the price of your home tank to eventually sending the country into another depression. Sounds pretty scary, huh?

Can anything be done to prevent deflation? The Federal Reserve Bank (the Fed), which is the central bank for the U.S., has already cut interest rates down to almost zero (currently, between 0 percent and 0.25 percent). This encourages borrowing, as lending rates are lower.

With lower lending rates, consumers may apply for more credit and begin to spend more. This will discourage deflation. Unfortunately, the credit markets are still sluggish, which means consumers aren’t applying for credit.

No new credit means no new spending, and no new spending can further drive down prices. Since the Fed has already cut rates to nearly nothing, they don’t have any room to cut them further. Some analysts believe that monetary policy becomes impotent when the Fed has the inability to further cut interest rates during times of slow inflation.

There is disagreement regarding this stance. In 2003, the Joint Economic Committee in the U.S. Congress published a paper, “Monetary Policy in Low Inflation/Deflation Environments,” regarding this very topic.

According to the paper, interest rates can be “misleading policy guides in low inflation and deflationary conditions.” The paper also states that it is a much easier thing to prevent deflation than to fix it.

Furthermore, when interest rates are at or near 0 percent (as they are currently), then people are apt to make inaccurate assumptions about the credit and financial markets. Most of the time, when interest rates are this low, they really don’t “say” a whole lot about any given market.

Apparently, outstanding government debt means that the Fed has the ability to purchase various assets and use these assets to incur inflation. These assets can include long-term securities, foreign exchange and even private debt.

The Fed can also commit to keeping rates low for an extended period of time (known as a “precommitment strategy”). Further, the Fed can begin lending directly to financial institutions.

Interestingly enough, the U.S. government is already implementing many of these strategies. Under the Troubled Assets Relief Program (TARP), $700 billion is being used to buy up private debt. Also, the Fed is already lending to individual financial institutions.

The Fed is already discussing buying long-term Treasury securities. Yet it has not committed to doing so.

Not mentioned in the Congressional paper is a program that the Fed has already unveiled. As a condition of the bailout, participating financial institutions are now required to modify the terms of many of their mortgages. So, in addition to using all of the policy instruments the Joint Economic Committee believes imperative to preventing deflation, the Fed is taking even greater steps to provide relief to consumers.

Even though deflation is something to be avoided and current conditions could tip into deflation, there are signs that it isn’t on the horizon. The Fed, in conjunction with the Treasury and the Congress, is using all the monetary policy instruments available to prevent deflation.

TARP, in addition to the current stimulus bill (the American Recovery and Reinvestment Plan), is doing a lot to slow the slide into deflation. With credit becoming more available and consumers getting the help they need (and not just in the form of trickling down from bailed-out corporations), spending should pick up. Then we can return to the good old inflationary days of old.