November 12, 2001

The Outlook

The Outlook

As the economy slides into near-certain recession, one seemingly heartening development has been the steady retreat of inflation. It may be time to worry about too much of a good thing.

Who could complain about prices barely increasing? George Akerlof, an economist at the University of California at Berkeley, and a winner of this year's Nobel Prize, for one. "This is potentially a very bad problem," he warns. Inflation, if it falls too low, makes it hard for the Federal Reserve to revive the economy, since the central bank's medicine is most effective when it cuts interest rates below the inflation rate. That can also pinch profits of companies unable to raise prices, and can punish borrowers who see the real value of their debts rise. Deflation -- falling prices -- makes those problems even worse.

Friday's producer price index report for October was the latest warning sign that deflationary pressures are rising. Wholesale prices fell 1.6% last month from September, the biggest one-month decline since the index began in 1947. Much of that was due to tumbling energy prices. But even excluding energy and food, prices were still down 0.5% , leaving them up just 0.8% from a year ago. The prices of intermediate goods such as chemicals, construction materials and steel stand at the same level they did in 1995.

For households, across-the-board deflation isn't here yet. In the year through September -- the most recent data available -- consumer prices were up 2.6%, an inflation rate in line with what had prevailed for the previous six years. But analysts expect that rate to head lower as well, starting with the October report coming out Friday. Consumers, wooed by zero-interest new-car loans and rampant markdowns at shopping malls, can see the writing on the wall. They expect an inflation rate in the next 12 months of just 0.4%, according to the University of Michigan's preliminary November consumer sentiment survey.

The odds of broad deflation in the immediate future seem low. Prices for cars and energy are unlikely to continue declining at their current rate. Economists project inflation of 2% next year, well above zero, according to the publication Blue Chip Economic Indicators -- though that could drop as economic weakness intensifies.

But even without deflation, inflation close to zero can cause problems. For example, economists expect nominal gross domestic product -- the dollar value for the country's economic output, unadjusted for inflation -- to shrink in the current quarter. That has happened only once in the last 40 years, in the first quarter of 1982, the middle of the worst recession since World War II. During most recessions, GDP actually rose when measured at then-prevailing prices. It was only after stripping out inflation that output fell.

That may sound like a technical distinction, but it can have important implications. Shrinking nominal GDP is akin to every worker and every business taking a pay cut. One consequence is that it sends debt burdens soaring. Think of someone who borrows $100,000 to buy a house with a 7% interest rate, expecting his salary to rise 3% a year, in line with inflation, making the loan easier to repay. Instead, his paycheck is cut 5%. His debt has grown relative to his income, and his interest payment is going to be much harder to pay -- even if prices of other things are going down.

"A contraction in nominal GDP runs the risk of generating significantly more defaults and bankruptcies than would be implied by a relatively mild drop in real GDP," say economists at Credit Suisse First Boston. Indeed, the default rate on junk bonds hit a 10-year high in October, according to Moody's Investors Service. Mortgage delinquencies and personal bankruptcies are both rising sharply.

Falling inflation, meanwhile, makes it harder for the Fed to soften those blows. Here's why: The Fed's main weapon for fighting recession is to lower the federal funds rate, which is the benchmark off which most other short-term rates are set. Cheaper money is supposed to encourage more borrowing, more spending and more investment. But the real cost of borrowing for households and companies is the real interest rate -- the rate they pay minus the rate of inflation. If inflation falls along with interest rates, all the Fed is doing is running in place.

True, the Fed has cut the target of its federal funds rate 4.5 percentage points to 2% this year, leaving it at its lowest nominal level since 1961. But that overstates how much the Fed has really acted. Because of the simultaneous drop in expected inflation, real interest rates have arguably fallen only half as much, argues Goldman Sachs economist Bill Dudley.

The most powerful thing the Fed can do to jump-start growth is move real rates to zero or below. But "with lower inflation, especially deflation, you may have significant, positive real rates of interest" even if the Fed's official rate is low, says Mr. Akerlof.

That is a big reason Fed Chairman Alan Greenspan has moved so aggressively this year, waging a furious race to get interest rates below a falling inflation rate. Until the economy shows signs of turning around -- and inflation stops falling -- Mr. Greenspan is likely to keep moving ever closer to zero.

-- Greg Ip

Write to Greg Ip at greg.ip@wsj.com¹

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