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Question of the Week - November 9, 2015

Question of the Week - November 9, 2015

Guest Post - Monday, November 09, 2015

Will we ever see inflation again? Where’s all this deflation coming from?

We would say be careful what you wish for, but like anything else in the economic realm, each of these conditions offers a double-edged sword.

Inflation, of course, is the general rising of prices. While everyone wants their wages to increase, this is not as useful if coupled with or surpassed by price increases in everyday goods, from groceries to gasoline—such impacts can cause ‘real’ (after-inflation) wage increases to net out to zero, or even fall behind if goods inflation is high or unpredictable enough. Economists and central bankers generally are of the belief that ‘some’ inflation (1-2% per year or so) is beneficial—mostly due to the fact that some manageable degree of price growth is a positive byproduct of economic growth, and growth is a desired thing. Too much inflation is naturally problematic, destabilizing and difficult to combat (U.S. in 1970s-early 1980s, Germany after WWI, some emerging market nations in various years), but finding that sweet spot of ‘just enough’ can be a tricky policy balance.

What’s the matter with zero inflation, especially if the prices of everyday goods are falling? On the surface, it doesn’t seem like a problem, but it can point to underlying issues that can be a problem if they persist. In the past several centuries, deflation has been relatively common, actually, in many countries—especially during periods of extreme technological change. The industrial revolution in Western nations resulted in dramatically more efficient means of production—by reducing labor needed and increasing production scale and volume—in a variety of goods, which correspondingly lowered their cost of production and selling prices. This carried over to transportation with the birth of railroads and faster shipping, which made a broader variety of goods more widely available. All impacts of reducing the costs of manual labor inputs and expanding supply has a depressing impact on prices, so as these generational themes played out, there was certainly growth in terms of societal productivity but prices fell. (The role of central banks was also minimal to non-existent in many cases during these periods, so the monetary end of this has to be discounted.)

Again, what’s the problem? In a vacuum, there doesn’t seem to be much, but when this is taken to a macro level, you can start to see where a reduction of needed labor can weigh on a reduced need for workers, depressing wages, all of which can start a downward household spiral. Also, if consumers believe that an item will be worth less tomorrow than today, they’ll hold off on making that purchase—especially large ones like autos or homes, but in all types of durable goods. This can exacerbate the negative spiral. Interestingly, these deflationary spirals are considered to be very difficult to pull out of, which is why central bankers are so weary of them and will push all buttons necessary to avoid them (quantitative easing in several Western nations and Japan being a prime example).

There are some parallels today. One especially big theme is related to demographic cycles. While the evidence relating GDP growth to investment returns is mixed, population growth and composition in certain parts of an economy is related to overall growth. Much of this is intuitive, as seen in many emerging markets today—a larger working-age population has more spendable income/spending power, so will generally purchase more goods (including more expensive ones) as wages and ages rise, through a fairly predictable pattern. Conversely, when demographics begin to work in the other direction, with fewer workers and more retirees, consumption should drop off. We’ve seen some of this, but granted, it’s fairly new territory, as longer life expectancies and longer retirements are a luxury that we’ve experienced in recent decades for the first time in history. A century ago, and even at the time of Social Security’s rollout in the 1930’s, retirement spans were morbidly short.

Secondly, a technological transformation that has occurred with the Internet and cell phone/smartphone technology over the last several years has rendered a wide variety of prior consumer products almost if not completely obsolete—including the film camera (for casual users anyway), but also stand-alone electronic devices like calculators, books, etc. As technology continues to become cheaper yet grows in functionality and power, the effect is deflationary. (By the way, this has been happening for several decades if not longer, as opposed to being a new development.)

What could generate inflation? Certainly, we could look back to history, which provides plenty of examples—both far-fetched and not so much. Monetary policy events, mistakes and intentional, such as depreciating a currency dramatically to lower the nominal value of external debt owed, or by a government regime losing credibility on the extreme side could certainly cause it. This creates a trade balance problem—cheaper home currency causes all other trading partner currencies to rise in value, generating imported inflation, which would hurt some countries more than others, depending on the goods involved. In less severe examples, even a slightly weaker currency can result in inflation ticking up. (One reason U.S. inflation has been low is the strong dollar, which has made imports from trading partners cheaper.) A reverse in the dollar’s strength, monetary multiplier effects and/or a commodity price shock could all serve as a catalyst for an inflation pickup.

No doubt, these situations move in cycles. Back in the late 1970s and early 1980s, inflation rose to extreme levels in the U.S., with fears that it was out of control, and thus, it was expected to move even higher. Today, deflation coupled with a global growth slowdown is the current fear. Behavioral finance tells us that we all expect current trends to continue indefinitely. But they don’t...although they can stubbornly persist for a while.

Additional Reading

Read our Weekly Review for November 9, 2015.

Read the previous Question of the Week for September 14, 2015.

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