The Fed Will Soon Need to Stem Deflation
Not only do we have a collapse in demand, but the eventual rebound in activity is likely to be anemic, too.
(Bloomberg Opinion) -- Federal Reserve Vice Chair Richard Clarida expressed confidence earlier this month that the U.S. could avoid an outbreak of deflation. I have become increasingly less confident that we can avoid such an outcome as rising anecdotal evidence of wage cuts reveals the magnitude of the negative demand shock that has slammed through the U.S. economy.
It was common early in the crisis to view the viral outbreak as a supply shock because, from the U.S. perspective, it appeared to be largely impacting the flow of goods from China. This original view suggested an inflationary impact from the virus.
The demand-side impact, however, now clearly dominates the economic outlook. Shutting large portions of the economy resulted in a collapse in spending and surging unemployment. While aid in the form of forgivable loans to small- and medium-sized firms and enhanced unemployment benefits can help keep the basic framework of the economic system glued together, it won’t solve the fundamental problem that economic activity requires actual customers. No customers, no firms. No firms, no employment.
Not only do we have a collapse in demand, but the eventual rebound in activity is likely to be anemic, too. Yes, in comparison to the dismal second-quarter numbers, the third quarter will likely bounce as some activity returns. This bounce, however, will not be sufficient to lessen the gaping hole in demand left by the virus. Large portions of the economy, particularly those related to travel and tourism, will still be encumbered by social-distancing restrictions. People will be wary to return to the full range of activities they pursued prior to the virus.
The result will be a protracted, substantial output gap that will weigh not only on inflation but inflation expectations as well. That shift in expectations will weigh on demand. For instance, a student recently asked me if I thought this was a crazy time to buy a car. I said it would be better to wait a few months for prices to come down instead.
What I find especially discouraging is the growing anecdotal evidence of widespread wage cuts. Such concerns also made their way into the Federal Reserve’s April Beige Book of economic conditions:
No District reported upward wage pressures. Most cited general wage softening and salary cuts except for high-demand sectors such as grocery stores that were awarding temporary “hardship” or “appreciation” pay increases.
We typically think of wages as sticky on the downside, an outcome attributable to a social aversion to wage cuts. Employees don’t like wage cuts for obvious reasons, and employers worry that wage cuts will hurt morale and retention.
This downward nominal wage rigidity prevents real (adjusted for inflation) wages from falling quickly during a recession, driving unemployment higher than would be the case under more flexible wages. The slow adjustment of real wages helps explain the long period of sluggish wage growth after the last recession, or what former Federal Reserve Chair Janet Yellen described as “pent-up wage deflation.”
Lower wages now are most certainly preferable to the alternative of high unemployment, as they spread the burden of the recession more broadly rather than concentrating it on the backs of a greater number of newly unemployed. Consider, though, what lower wage rates and salaries tell us about the magnitude of the shock that just hit the economy. It must be truly massive when even a protracted period of unemployment as high as 10% in the last recession didn’t crack the resistance to wage cuts. Even in the Great Depression, wages stayed high until 1931 before succumbing to the same deflationary forces as prices.
The Fed will not be complacent to the deflationary implications of falling wages, but at the moment it is primarily focused on ensuring smooth functioning in financial markets via a wide array of liquidity programs. The goal of these programs is to prevent a financial meltdown that would only intensify the deflationary pressure. Those programs will probably be the emphasis of this week’s policy meeting.
Still, watch for deflation concerns to eventually reveal themselves in increasingly strong language reinforcing the Fed’s commitment to a 2% inflation target followed by forward guidance to more strongly lock in expectations that the central bank will not reverse policy easing anytime soon. So, keep an eye out for falling wage rates and salaries, as that would indicate strong deflationary forces are at play, raising the odds that this recession evolves into a depression.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Tim Duy is a professor of practice and senior director of the Oregon Economic Forum at the University of Oregon and the author of Tim Duy's Fed Watch.
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