Fearing inflation, deflation becomes the unnecessary evil

Fearing inflation, deflation becomes the unnecessary evil

Was the US Central Bank right to delay a planned rise in interest rates? The increase was anticipated to beat down inflation before it got out of hand.  Instead, Chairwoman Yellen and her team “wimped out.”

Let’s provide some context first. Following the banking crisis that resulted in the 2008 recession, The US Federal Reserve engaged in unprecedented monetary stimulus through buying bonds, driving real and nominal interest rates to historic lows. Most GOP commentators forecasted high inflation because all else equal that much monetary stimulus should have driven inflation into the double digits. Many business leaders accepted these projections as fact. The fear still hangs over us.

Those inflation projections were flat out wrong. Why? Because the “all else equal” condition did not hold true. Banks used extra reserves to build up capital rather than lend, preventing the Fed’s bond-buying action from increasing the money supply and stimulating inflationary forces.

The bankers’ response was rational. Bank capital needed replenishing. Loan demand had fallen, and remaining applicants looked riskier than in the past.  Inflation was not just unlikely; the recession planted deflationary seeds. Yellen appears to believe these seeds may sprout if she raises interest rates too soon. She delayed raising rates at the last Fed meeting as a result.

The one part of economics that cannot lie is its algebra. Gross Domestic Product (GDP) (a universal measure of economic activity, closely aligned with National Income) is the sum of underlying components. To increase GDP requires growth in consumption, investment, government spending, or exports net of imports.  Think of our economy as a biker on a GDP hill with these four components creating the strength in our lungs and legs. Monetary policy is wind – at our back if expansionary or in our face if contractionary. At first, steady wind from behind helps us up the hill. We avoided Europe’s economic woes thanks in large measure to the Fed’s monetary stimulus.

The bicyclist tires when businesses, facing too little demand and too much uncertainty, hold back on investments. He stalls when consumers face stagnant wages, unemployment, school debt, and credit issues. In response, they reduce their spending on housing, durable goods, clothing and fun evenings out. Add in our worsening trade imbalances, where import growth exceeds export growth, and the biker has a hard time holding ground, much less returning to pre-recession GDP levels. (See Chart which shows shortfall of economy from its potential.)

With far more supply of goods and labor than there is demand, there’s no price or wage-setting mechanism for inflation; expansionary monetary policy does nothing. In these situations, the real risk is deflation – a decline in prices. It exists in Europe where monetary policy remained tight until recently. When prices fall, worrisome events follow.

First, purchases are delayed in anticipation of lower prices. Second, debtors face crises, as loans established at higher price levels are harder to pay back. Bank reserves fall with higher levels of defaults than usual, so banks are forced to reduce lending.  Finally, because employers rarely cut wages, real wages go up in deflationary periods. The rise reduces demand for labor and exports, creating yet more deflationary forces.

In essence, deflation loads the biker with a 100-pound weight in his pack and going backward becomes a real risk. A recession turns into difficult-to-reverse stagnation, as Japan has experienced. The US Federal Reserve, thankfully, has kept us from this danger.

Where are we now? The economy has improved. Unemployment is down, and our biker on the hill has some momentum. Does the biker still need the wind? The no voters argue a failure to raise interest rates will create asset bubbles and make it hard to arrest inflation. The yes voters point to the following arguments.

First, China’s economy is slowing down considerably. Second, our exports are slowing as nations depreciate their currency against the US dollar to increase their exports and reduce ours. Third, with recent global stock market declines, asset bubbles are unlikely. And finally, there’s little sign of inflationary pressure in wages or prices. So why create a headwind when a weak biker is trying to move up the hill?

People are still fear-struck by 2008. Any downward momentum can, therefore, produce a quicksand of slow growth and deflation. I for one think the Fed made the right call.

The experience has also taught us a lesson as business leaders: facts are often  assumptions disguised as facts.

More articles by Kay Plantes

Kay Plantes is an MIT-trained economist, business strategy consultant, columnist and author. Business model innovation, strategic leadership and smart economic policies are her professional passions. She resides in San Diego, California but still considers Madison home. She is the author of Beyond Price.The opinions expressed herein or statements made in the above column are solely those of the author, and do not necessarily reflect the views of WTN Media, LLC. WTN accepts no legal liability or responsibility for any claims made or opinions expressed herein.