And Now Deflation?
Subject Deflation
Topic Employment, Unemployment, and Inflation
Key Words Deflation, Personal Consumption Expenditures, Consumer Price Index,
Interest Rates, Federal Reserve
News Story

Much of the focus of economists in the past 40 years has been on inflation. The opposite situation – a period where the average price level decreases - has either not been given any attention or has been thought of as something that would be beneficial. The Commerce Department reported a decline of 0.4 percent for the third quarter at an annual rate for personal consumption expenditures; this is the first quarterly decline since 1954. Deflation, as Japan has discovered, can be a significant problem.

The Consumer Price Index is the most widely recognized measure of inflation. The CPI tracks price changes for a fixed market basket of goods and services. Personal Consumption Expenditures tracks price changes for a greater number of goods and services. The PCE minus expenditures for food and energy, the core PCE, is an economic series to which many economists, especially Alan Greenspan, chairman of the Federal Reserve, pay close attention.

Although prices typically decline during recession, widespread price declines have not occurred in the seven recessions since 1954. Deflation can be a problem if declining prices cause consumers to postpone purchases in the belief that future prices will be even lower. Because wages are difficult to cut, corporate profits get squeezed during deflationary periods leading to layoffs and reduced incomes. This is the problem Japan is currently facing. To be sure, there are some benefits from decreased prices. Gasoline price cuts, for example, are almost the equivalent of a tax cut.

In contrast to previous recessions, there are some signs of deflationary pressure. The Commodity Research Bureau index of raw material prices is down 15 percent this year, off 40 percent from its 1995 peak. In addition, the National Association of Purchasing Management reported that the purchasing power of manufacturing companies is at its lowest level since 1949.

Interest rate cuts are typical measures used to fight recession. Interest rate cuts provide an incentive for business and consumers to increase their spending. The magnitude of the stimulative effect also depends on the rate of inflation, with greater incentives being provided when the inflation rate is lower than the rate of interest. Cutting interest rates to counter recession can therefore be a problem during deflationary periods.

(Updated December 1, 2001)

1. What happens to the purchasing power of the dollar when inflation increases? When inflation decreases?
2. How is the Personal Consumption Expenditures index calculated? How does it differ from the CPI? Which is a better measure of inflation?
3. The housing and automobile sectors have been aided by the decline in interest rates. Why are these two sectors especially sensitive to interest rate changes?
Source Floyd Norris, "For the First Time Since Ike, a Whiff of U.S. Deflation," The New York Times, November 2, 2001.

Return to the Employment, Unemployment, and Inflation Index

©1998-2002  South-Western.  All Rights Reserved   webmaster  |  DISCLAIMER