Monday, January 12, 2009

Deflation

I briefly discussed the reasons for currency, now let's go over what can go wrong with it.

Deflation

Deflation is what we call it when prices drop and keep dropping.

Aren't low prices a good thing? Well, yes if you have a job. However, if people don't buy goods at lower prices, here's what happens:
  1. Goods build up in the warehouses
  2. Producers no longer get orders for new product
  3. Producers lay off workers
  4. Laid-off workers have less income
  5. Lower income means fewer people to buy
  6. Return to step 1
Any economic cycle has an end. However, a deflationary cycle terrifies people who run banks. Here's a lecture from Ben Bernanke (currently the Chairman of the Federal Reserve -- the Fed for short) back in 2002 about deflation:
However, a deflationary recession may differ in one respect from "normal" recessions in which the inflation rate is at least modestly positive: Deflation of sufficient magnitude may result in the nominal interest rate declining to zero or very close to zero. Once the nominal interest rate is at zero, no further downward adjustment in the rate can occur, since lenders generally will not accept a negative nominal interest rate when it is possible instead to hold cash. At this point, the nominal interest rate is said to have hit the "zero bound."
He continues warning what to do about this:
First, the Fed should try to preserve a buffer zone for the inflation rate, that is, during normal times it should not try to push inflation down all the way to zero.
The current overnight rate is at 0-0.25%. We are now at the "zero bound" Bernanke talked about in 2002.

So what was his plan if we get to that point?
So what then might the Fed do if its target interest rate, the overnight federal funds rate, fell to zero? One relatively straightforward extension of current procedures would be to try to stimulate spending by lowering rates further out along the Treasury term structure--that is, rates on government bonds of longer maturities.
Oh, yes that's happening now. 30-year Treasury yields had been falling, and now are going up again. Bernanke continues:
Sustained deflation can be highly destructive to a modern economy and should be strongly resisted. Fortunately, for the foreseeable future, the chances of a serious deflation in the United States appear remote indeed, in large part because of our economy's underlying strengths but also because of the determination of the Federal Reserve and other U.S. policymakers to act preemptively against deflationary pressures.

...

prevention of deflation is preferable to cure. Nevertheless, I hope to have persuaded you that the Federal Reserve and other economic policymakers would be far from helpless in the face of deflation, even should the federal funds rate hit its zero bound.
The wonky explanation about deflation is that the money supply contracts. That is, there are fewer dollars chasing the same goods. That can happen because of high interest rates (meaning it costs more to borrow, so people don't borrow as much) or in our case, a general depreciation of assets (housing and stock crash anyone?).

To counter this, theory is to use tools to increase the money supply. We can't lower the interest rates (they're at that zero bound), so what can we do to increase the money supply? Why, print more money! In fact, the non-asset money supply has been increasing (so the printing has been going on for some time now). Here was the headline on the Drudge Report a few days ago:

Looks like they're doing their best to avoid deflation. But what does that lead to? Inflation.

We'll talk about Inflation next.

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