NCPA - National Center for Policy Analysis

Dangers of Deflation

September 21, 1998

The Bureau of Labor Statistics has just announced that producer (wholesale) prices fell 0.4 percent in August. So far this year, producer prices have fallen at an annual rate of 1.4 percent. Other price indicators are also showing deflation. Yet many analysts continue to see inflation as the true threat, confusing changes in some relative prices with changes in the general price level.

Others argue that while producer prices and commodity prices may be falling, consumer prices are still rising at about a 2 percent annual rate. However, it is well known that the Consumer Price Index has an upward bias. Even so, Forbes Magazine notes that many consumer prices are also falling. It points to autos (Ford Taurus, down 5.3 percent), gasoline (down 16 percent), coffee (down 25 percent) and milk (down 27 percent).

Deflation can be a more serious problem for the economy than inflation. A major reason is that interest rates cannot fall enough to compensate for falling prices because nominal (market) interest rates can never fall below zero. But if prices are falling, even a very low nominal interest rate (Japan's is down to just 0.25 percent) can be high in real terms. If one borrows money at 1 percent but prices fall 5 percent, the real interest rate is actually 6 percent (see figure).

Furthermore, to the extent that deflation indicates a tight monetary policy, lack of liquidity in financial markets can drive up interest rates. According to economist Steven Leuthold, once deflation rises above 1 percent, interest rates tend to rise, just as they do during inflations. This means that extraordinarily high real interest rates are possible during deflations. This is what causes mild economic downturns to become depressions.

Source: Bruce Bartlett, senior fellow, National Center for Policy Analysis, September 21, 1998.


Browse more articles on Economic Issues