As Economy Slows, Deflation Could Loom

By Michael A. Fletcher
Washington Post Staff Writer
Tuesday, October 7, 2008

After steep price increases that sparked concerns about inflation earlier this year, many prices have fallen lately. Oil and other commodity prices are down sharply since midsummer. Housing prices have continued their long slide.

Meanwhile, consumer spending has slowed and the economy is shedding jobs at an increasing rate. Credit markets are frozen.

The confluence of trends has some economists worried that the country could be headed for a debilitating cycle of deflation: a period in which weak consumer demand, falling prices and tight credit ignite a downward spiral of still weaker demand and still lower prices. Under this scenario, as some businesses are strangled, joblessness increases, feeding the cycle.

"It was just a few months ago that everyone was obsessed with inflation. Now it's deflation," said Bill Gross, co-chief investment officer at Pimco, an investment management company. "I think it's a possibility."

The value of a wide range of assets, from commercial real estate to stocks and bonds, has declined over the past year. Concerns about falling asset prices are compounded by a banking and credit crisis that has quickly become a global contagion.

For now, even as Gross and many other analysts see declining prices as cause for concern, they are reluctant to say the country has entered a deflationary period. And if prices fall much further, they said, the Federal Reserve has been given the tools necessary to stave off disaster.

"Right now, the declining supply of money for investment and credit is a reality," said Jacen A. Dinoff, managing partner of KCP Advisory Group, a financial consultancy. "We have lending institutions who are being very careful. They are closely scrutinizing new loans and tightening belts on existing ones. Could deflation be around the corner? It could be."

Some economists note that a period of price adjustments does not necessarily signal the start of a deflationary spiral.

"Deflation is not the problem we should be worrying about," said Adam Lerrick, an economist at Carnegie Mellon University. "A drop in the level of prices for some goods must be distinguished from a continuous fall of prices. Oil is down to $90 from $140, but does anyone expect it will be $55 a year from now and $35 in 2010?"

Analysts said that a few months of price declines should not be a problem for the economy.

But if prices continue to fall across the board for a prolonged period, the declines will weigh heavily on businesses and consumers, particularly those juggling a lot of debt, which must be paid back even as money is harder to come by.

"For a few quarters, I say bring it on, but not for too much longer," Gross said of deflation. "Capitalism depends on mild inflation. Unless we get it, the dynamics of capitalism sort of move in reverse."

Japan is the cautionary tale that economists point to when it comes to deflation. Beginning in the 1990s, the nation spent a decade wrestling with flat growth as consumer prices declined about 1 percent a year. The result was not only painfully slow growth, but also rising joblessness -- a problem that economists said was fed by the slow response by Japanese central bankers to a stock and real estate crash that sparked the downward spiral.

In the United States, policymakers have been much quicker to respond to deflationary threats. Five years ago, as inflation approached 1 percent, spawning deflation concerns, Alan Greenspan, then the Federal Reserve chairman, cut the Fed's benchmark lending rate to 1 percent and the threat was never realized. It is an outcome that gives assurance to some economists.

"As long as governments print money and run deficits, you cannot have deflation," Lerrick said.

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