NCPA - National Center for Policy Analysis

What Does Deflation Look Like?

September 11, 1998

Americans know all too well the effects of inflation, but have never experienced deflation. Some economists believe we are entering a period of deflation -- described as a fall in general price levels -- which could be beneficial or just as troublesome and difficult to manage as inflation.

Falling prices must be persistent, dropping over two or more quarters, to be considered deflation, economists point out.

  • If deflation is triggered by increased productivity, it can be beneficial -- increasing consumers' purchasing power, improving real incomes and earnings and leading to lower interest rates.
  • But if deflation is caused by a fall-off in demand, watch out -- because that will reduce corporate profits, leading to layoffs and reduced spending.
  • Between 1865 and 1899, average prices dropped by 45 percent because productivity was exploding.
  • But between 1929 and 1933 -- while the money supply was shrinking by one-third -- the nation was enveloped by the Great Depression with falling demand and unprecedented joblessness.

Economists such as American Scandia's Lawrence Kudlow fear the U.S. may be entering a period of deflation caused by too tight a money supply. They note that commodities prices -- especially gold -- have plummeted in recent months, profits aren't looking good and economic growth has slowed. Such economists are calling for the Federal Reserve to lower interest rates and loosen its grip on the money supply.

But another school of economic thought contends that inflation is still the greater risk. They point out that general prices -- as measured by the CPI -- haven't been falling, but continue to rise, although at a slower rate. They also argue that the money supply may be growing too fast.

Source: Charles Oliver, "Deflation: The Next Economic Debate," Investor's Business Daily, September 11, 1998.


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