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How a touch of inflation could boost the economy

By Neil Irwin
Saturday, September 18, 2010; A8

Americans generally view rising prices as something to fear. But right now, a little inflation may be just what the economy needs.

Consumer prices rose 1.2 percent over the 12 months that ended in August, the Labor Department said Friday, and only 0.9 percent when volatile prices for food and energy are excluded. That is well below the range of 1.5 to 2 percent sought by the Federal Reserve.

The low inflation numbers reflect the reluctance of businesses to raise prices amid weak demand for their products and the inability of most workers to get raises at a time of high unemployment.

Somewhat higher inflation could strengthen the ailing economy. Inflation would make the heavy debt that Americans carry a bit more manageable as wages rise but the amount owed stays the same. And it would create more incentive for businesses to invest their cash rather than sit on it, because inflation would reduce the value of hoarded money.

Some economists fear outright deflation, a destructive, self-reinforcing cycle of falling prices that can cause a long period of economic misery.

But economic data released in recent months reveal a different reality: Prices are rising very, very slowly, and appear set to keep doing so for a long time to come. Investors expect inflation to average 1.2 percent over the next five years, according to data from the bond market.

Even if the United States can avoid the kind of deflation that crippled the Japanese economy in the 1990s, the current economic recovery could suffer if extremely low levels of inflation become the norm. The current rate of inflation may be just high enough to keep Fed policy makers from taking bold action to try to invigorate the recovery, but just low enough to represent a continued drain on economic activity.

"If that kind of equilibrium forms, you can get stuck in a really suboptimal situation," said Tim Duy, a University of Oregon economist.

With deflation, consumers and businesses respond to falling prices by sitting on cash, because it will become more valuable in the future as its buying power increases.

Hoarding, in turn, weakens the economy further, putting more downward pressure on prices.

But that vicious cycle doesn't suddenly kick in only when inflation moves from slightly positive to slightly negative. For example, businesses that forecast a very low rate of inflation would be more inclined to hold onto cash than they would if inflation were higher. Yet without new investment, the jobless rate could remain high, keeping wages - and ultimately prices - from rising.

Fed policymakers could try to break this cycle with large-scale purchases of bonds, essentially flooding the economy with hundreds of billions of dollars in new money. The Fed will discuss such an approach at a policy meeting Tuesday but is unlikely to take the steps then.

Some Fed officials argue that prices will begin to rise more rapidly, even without dramatic action by the Fed, once the economic recovery gains momentum.

Fed leaders, meantime, have played down the risk of outright deflation, even as they seem increasingly concerned about inflation below the level they informally target.

"While no member saw an appreciable risk of deflation, some judged that the risk of further near-term disinflation had increased somewhat," according to minutes of the Fed's Aug. 10 policy meeting.

The Labor Department said Friday that consumer prices rose 0.3 percent in August, but that spike was mostly because of a jump in the price of gasoline, which can change dramatically from month to month. Excluding food and energy, the consumer price index rose 0.1 percent.

Among the prices that fell in August: Rents fell 0.7 percent, hotels and other lodging rates fell 1.3 percent, and apparel prices fell 0.1 percent. Education costs, which have been on a long upward trend, were unchanged.

"With companies focused on cost cutting and productivity and the consumer still dealing with excess leverage, price pressures are absent from the economy," said Steven Ricchiuto, chief economist at Mizuho Securities.

The dip in annual inflation excluding energy below 1 percent "shows that the economy is just one modest contraction away from dipping into a Japan-like deflation," he said.

Several sources of information give Fed officials solace that the U.S. economy hasn't reached that stage. For one, inflation expectations, which have a tendency to be self-fulfilling, have been little changed since early August, as measured by surveys of economic forecasters, of ordinary Americans, and bond market data.

And commodity prices have been drifting upward slightly this summer, despite signs that the global economic recovery is faltering. The price of oil had edged up from $68 a barrel on May 20 to $73.66 Friday.

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