Deflation Would Be a Crippling Side Effect of the Pandemic

With demand for many goods and services wiped out by efforts to contain the deadly outbreak, there’s a new concern that the economy’s sudden and severe stumble could lead to a dangerous phenomenon known as deflation, when overall prices drop. “The risk is definitely toward deflation,” says Julia Coronado, president of Macropolicy Perspectives LLC. “We’re not quite forecasting it, but that’s where the risk lies, and that would contribute to rising business failures in a negative feedback loop.”

Americans are already getting the first taste of it. Food prices jumped in April, but overall inflation, as measured by the consumer price index, fell 0.8% from March. Another important measure, prices paid to U.S. producers, dropped 1.3%, the most in data going back to 2009.

If falling prices sound like an attractive scenario, think again. A few such months can be easily weathered—the U.S. had eight straight months of year-over-year deflation in 2009. But an extended run can wreak considerable havoc. It’s a sign that “something else is royally screwed up in the economy,” says Jeffrey Fuhrer, a senior fellow at Harvard’s Kennedy School of Government. The last time the U.S. dealt with a deep and extended period of deflation was 1930-33 during the Great Depression, when prices tumbled almost 25% over four years.

Deflation can become more than just a symptom of deep dysfunction. It can be its own destructive force that makes a bad situation worse. Once it takes hold, consumers become ever more hesitant to make big-ticket purchases because that refrigerator, car, or addition to your house will all cost less if you wait a year. Even if this occurs only at the margin of every household budget, the accumulated impact can be damaging, slowing an already faltering economy.

The key, says Robert Rich, director of the Center for Inflation Research at the Cleveland Federal Reserve, is where people think prices are going. “If, somehow, these initial periods start to become ingrained in people’s expectations, then we can get into a very bad situation and a possible deflationary spiral,” he says.

Deflation is also tough on borrowers. In a healthy environment of largely steady 2% to 3% annual inflation, if your income merely keeps pace with prices, payments on your fixed-rate mortgage or car loan become more affordable with every passing year. That benefit disappears amid very low inflation and can go into reverse if prices and pay decline. In that case, your mortgage grows as a proportion of your income.

Then there’s the factor that troubles central bankers most about deflation: It’s hard to solve. When inflation is running hot, the cure is painful but plain enough: Jack up rates as high as it takes to put the brakes on economic activity. That forces prices back down as the resulting unemployment trims wages and spending by individuals and businesses.

With deflation, it’s hard to do the reverse and get rates low enough to provide the stimulus that will drive an economy out of the ditch. Japan, which has struggled through repeated bouts of deflation since the 1990s, has seen only limited success with negative rates. Over the past 25 years, its economy has averaged growth of less than 1% a year. “From a central bank’s perspective, we understand what needs to be done to bring down inflation,” Rich says. “But a deflationary episode represents a much greater challenge. Once expectations change and become more in tune with that environment, it becomes much more difficult to achieve an inflation objective.”

Most economists see extended deflation as still avoidable. Prices don’t have to recover to pre-crisis levels; they simply need to stop falling. That should occur with even a very modest level of growth in the second half of this year.

More than one scenario might disrupt a second-half recovery, however. An obvious one involves a resurgence of the virus should business reopenings prove premature. Even without that, the damage done since March could mount should too many companies fail to make it to the other side of the shutdown. In the view of many economists, that puts the onus on Congress to pass another stimulus package to prevent a wave of business bankruptcies and stave off severe budget cuts by state and local governments. “Right now, the odds of avoiding deflation are the odds of Congress and the administration being willing to approve additional support for the economy,” says Bloomberg chief U.S. economist Carl Riccadonna.

So far, Republicans have balked at the Democrats’ proposal for another massive relief bill, which would add $3 trillion in spending to $2.2 trillion already approved. Debate over a compromise is likely to continue for weeks.

Escaping the deflationary spiral, however, will still leave the U.S. economy in a vulnerable, Japan-like spot. Pre-pandemic, annual CPI inflation in the U.S. over the past decade averaged just 1.8%. By the Fed’s preferred inflation measure, it was even lower, at 1.5%—half a point below the central bank’s 2% target.

That’s part of the reason interest rates never got very high after the last recession, and partly why the Fed had little room to cut them when Covid-19 came along. With a tepid recovery on the horizon, that will leave inflation even lower for the foreseeable future.

This is just the trap the Fed hoped to avoid when, in 2019, it conducted a yearlong review of its policy framework, hoping to settle on a strategy for getting inflation and rates to move higher. “The concerns that motivated the framework review seem kind of quaint today,” says Harvard’s Fuhrer, who until this year served as a senior policy adviser at the Federal Reserve Bank of Boston. “I would wager, if not predict, that problem comes back in worse shape than it was before the crisis.”
 
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