Inflation or Deflation?

One of the important arguments economists and investments strategists are currently engaged in is whether we are in for a period of inflation, even hyperinflation, or deflation. There are good arguments and smart people on both sides of this one.

Until very recently the inflationists had the upper hand. It was only a few months ago when the monthly CPI was over 6%, a very high number for the recent past. (CPI = consumer price index, a broad measure of inflation.) Others, however, have warned that this was a transitory spike and the real threat was deflation.

Today, as reported in The New York Times and elsewhere, it was announced that CPI fell 1.7% last month, a record drop.

In just six months, economists who had fretted about out-of-control inflation as oil peaked near $150 a barrel are now warning of deflation as prices drop as the economy grinds into a lower gear.

“I’ve never seen the economy slam on the brakes as much as it has in the last three months,” said Bill Hampel, chief economist at the Credit Union National Association. “And as the tires are squeaking on the pavement, that’s pulling prices down too.”

Deflation is a much more difficult problem to deal with than inflation. The Federal Reserve can raise interest rates to help reduce inflation, but there are fewer tools to help with deflation.

It has been widely reported that Ben Bernanke, the Chairman of the Federal Reserve, earned the nickname “Helicopter Ben” when he wrote a paper prior to joining the Fed, that he would fight deflation by throwing money out of helicopters to spur spending. I don’t know if that was meant as a joke, but printing and distributing new money is one of the few tools the Fed has to fight deflation.

Deflation has been a major problem in Japan since the early 1990s, one they have not been able to solve, and one that has contributed significantly to their overall economic problems. As reported in today’s Wall Street Journal:

Normally, such signs of rapid price drops would be hailed as a welcome reprieve for households that saw their purchasing power crippled earlier in the year by soaring energy and food prices. But in the current climate, the inflation data reflect the hard economic times that are causing consumers and businesses to delay purchases. In its worst form, that process is known as deflation, which was blamed for Japan’s deep economic slump earlier this decade.

For those not too familiar with deflation, here’s a quick, superficial explanation. Deflation is the opposite of inflation, a condition where prices drop rather than rise. While that may sound appealing at first glance, it is extremely problematical as consumers delay making purchases, further reducing economic activity. Ideally an economy has a small level of inflation in order to spur consumers to make purchases before prices rise.

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