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Deflation Demons

U.S. inflation is low: the CPI rose 2.1% from a year
ago. Except for a brief stint in 1986, the U.S. has not seen inflation
this low since the mid-1960’s. The current low levels of inflation are
starting to raise some concern over the possibility of deflation. The concerns
are only beginning to trickle in since unemployment
is low
and growth
is high
– historically a recipe for higher inflation – and we are used
to worrying about the risk of higher, not lower, inflation. However, if
inflation continues to remain low, or falls further, the specter of falling
prices will loom larger in policy debate.

For those not immediately familiar with the economics of deflation,
the prospect of falling prices does not immediately sound alarm bells —
if inflation is bad why isn’t deflation good? The logic is relatively straightforward,
but takes a couple of steps to get there. The short summary is that falling
prices limits the ability of the Fed through monetary policy to fight recessions,
and downturns are likely to become more severe in a deflationary environment.

The longer story begins with interest rates, and how inflation determines
the minimum level that the Fed can set.

Nominal and Real Interest Rates

An important distinction to make when talking about interest
rates
is the difference between “nominal” and “real” rates. Q: What’s
the difference? A: (Quite literally) Inflation.

Say you take out a loan of $100 and after a year you must pay back $110.
The nominal interest rate is then 10%. However, after the year has passed,
the prices of all goods and services have risen by the rate of inflation.
Say that the rate of inflation is 3%. The money that you have to pay back
is only really worth about $107 because of the 3% erosion of the value
from inflation.

Thus “real” rate of interest that you pay is then only 7% since you
are paying back money worth $107 for the original loan of $100. It is called
a “real rate of return” since the amount you borrow and the amount you
pay back are both measured in terms of real goods and services rather
than in terms of the money, whose value may not be constant through time.

 


















































Loan Amount $100
Nominal Repayment Amount $110
Nominal Interest Rate (110-100)/100 = 10%
Nominal Repayment Amount $110
Inflation 3%
Real Repayment Amount $107
Real Interest Rate (107-100)/100 = 7%
Nominal Interest Rate 10%
 – Inflation Rate  – 3%
Real Interest Rate 10% – 3% = 7%

 

There are two things to note about real and nominal rates. The first
is that investors should only really care about the real rate of interest
on loans. Investors care about the real (inflation adjusted) amount of
money they will have to pay back at the end of their loan term, and thus
they look at the real rate of interest. The second is that, as you’ve probably
guessed from the example above, there is a simple relationship between
the two interest rates and inflation: real interest rate = nominal interest
rate – inflation rate.

So what does this have to do with deflation? The next link is how monetary
policy works to control the pace of the economy.

Deflation and Monetary Policy

The Federal Reserve System is typically thought to be able to control
interest rates. If the economy is “overheating” and inflation is threatening
to rise, the Fed can raise interest rates and slow investment and hence
the economy as a whole. On the other side, if the economy needs a boost,
the fed will lower interest rates.

Now here is the important part – the Fed can move only nominal rates.
From above, investors care about the real rates.

Say that a recession hits and the Fed wishes to lower rates – how far
can they go? The Fed can only lower nominal rates to zero, but if there
is inflation, the real interest rate – the one we care about – can go below
zero.

But what if there is deflation? In this case the real interest
rate can only go as low as the rate of deflation. If prices are falling
at 5% per year, interest rates can only drop to 5%. The potential then
arises from a spiral in which a recession brings falling prices, which
automatically raises interest rates, which leads to further recession and
greater deflation, and so on.

It is this deflation – recession spiral that makes many worry about
inflation falling to zero.

Conclusion

When everything is going well, deflation does not pose much of a problem.
The concerns arise when a recession appears on the horizon. If prices are
falling, then the ability of the Fed to adequately pull us out of a downturn
is weakened. The risks of entering a deflation – recession spiral will
begin to become a more salient aspect of monetary policy if the current
low rates of inflation persist even in a booming economy.

What do you think about the possibility of deflation? Other Comments?
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See Also:




Inflation (CPI growth)

Source: Historic: BLS
or current.
 




Current Rates 

The current Federal funds rate is around 5.5%. 30 year t-bills are at
about 6%, and Aaa bonds at 6.8%. 

Subtracting the inflation rate the real rates are between 3.4% and 4.7%. 

 

Source: Federal
Reserve Statistical Release H.15 – About the release
 

 


 

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