U.S. Prices – A Chilly Breeze of Deflation

United States economic policy will not allow a general decline in prices. It could be that inflation is returning in a roundabout way.

It is pointless to argue about whether prices in the U.S. are just now slightly falling or are still barely rising. The most recent data is suggestive of both possibilities. The general consumer price index (CPI) has declined in the 12-month period ending in March for the first time in over 50 years. The core inflation rate, which does not include energy and food costs, still remained just under 2 percent in the same time period.

In this serious economic crisis, it is important to note that all signs are pointing toward a drop in prices. A deflationary period must be combated before it actually appears. What makes this so dangerous is that a falling level in prices will set into motion a self-perpetuating and strengthening downward spiral against which there is really no antidote, as was the case in Japan in the 1990’s. Although a Japanese scenario is still highly unlikely in the U.S., this possibility can be only because of an extreme expansion strategy that monetary policy makers in Washington have pursued for some time.

The deflationary forces are obvious. U.S. retail industry sales have recently fallen once again. U.S. industrial output contracted in the first quarter at an annually adjusted rate of 20 percent, and has been operating at only 70 percent capacity. This was the lowest degree of utilization since 1967, when such data was first collected.

In such an environment of massive overcapacity and persistent reluctance to make purchases, companies are not able to raise their prices. Instead, they must adapt to intense price wars. Because the true interest rate increases when prices fall more than interest rates, it can then be difficult to offer credit. Consumers who are expecting that everything will be even less expensive tomorrow will delay their purchases, which will lead to an intractable deflation.

U.S. economic policy is pitting itself against this possibility by using all means at its disposal. This year, the budget deficit will probably surpass 10 percent of the gross domestic product. Purchases financed by this deficit spending will likely be partially offset by consumers’ new thriftiness.

The Federal Reserve Bank not only has cut its prime rate to near zero and stabilized the banking system; it has also pumped freshly printed money into the economy and into the coffers of the states. Federal Reserve Chief Ben Bernanke has left no doubt that he will do whatever is necessary to ward off deflation.

Because the danger of prices spiraling downward is so real at the present time, it is likely that this policy will stop it sooner or later.

Whether this policy can contain such a situation and then, sometime later, set into motion another increase in prices, is quite another question. Should financial markets lose faith in and seriously devalue the dollar sometime in the future, inflation could make a big return in the United States.