Forget Inflation, Deflation Is a Bigger Danger

Is this the time to worry about inflation? We are, after all, awash in money with stagnant output.

In the past year, the Federal Reserve has increased our monetary base by about 120 percent, more than double the previous highest annual increase over the past 50 years. The Fed has made huge loans to private lenders and bought over $1 trillion of mortgage securities and hundreds of billions of dollars of long-term treasury bonds. It has succeeded in lowering the federal funds rate below 1 percent—even, for most of the time, to less than half that. The goal, of course, is to force-feed money into the economy in the hope of sparking a recovery.

The mountain of reserves on bank balance sheets, which so scares the inflationary hawks, would normally encourage banks to lend and increase their profits. But while the Fed has been pumping money through the banks, little of it has entered the economic mainstream. Instead of boosting lending, the banks have just increased their reserves at the Fed by hundreds of billions of dollars.

The government may be borrowing more, but consumers and businesses are borrowing less. If anything, they are paying down their debts. Households will reduce their total debts by $200 billion this year, Forbes magazine projects, and banks and businesses by $2.3 trillion. Small-business lending will contract by at least $113 billion. Since the credit crisis began more than two years ago, credit available to consumers and the small-business sector—which employs half of the country's workforce—has contracted by trillions of dollars, mostly because of curtailment of credit card lines. The hope that new bank reserves would be available to prop up the faltering economy has not been fulfilled.

Inflation typically results from "too much money chasing too few goods." Today, too much supply is chasing too little demand. That, coupled with consumers' need to save money to rebuild their finances, raises the risk of deflation, not inflation. As workers compete for scarce jobs and companies underbid one another for sales, both wages and prices will remain under pressure. We began this crisis with household debt at its highest levels since the 1930s. Knowing that monthly mortgage payments don't shrink even if your paycheck does, families are trying to deleverage and work down what they fear is their excessive debt. On top of that, households are suffering from substantial wealth losses tied to impaired equity portfolios and dropping home values. The combination of lower incomes and reduced wealth raises the likelihood that consumers will continue to boost their savings and pay down debt rather than spend more on consumption, which has put retail spending into one of its worst declines in decades. This is evidenced by retailers slashing inventories by record amounts, causing the percentage of capacity utilization in manufacturing to drop to the lowest reading in the 50-year history of the measure.

Demand growth would need to recover substantially to reverse the deflationary effects of low capacity utilization. For this, we would need a significant improvement in employment and hence spending. But the job market is even worse than the overall economy, and the prospect is that high levels of joblessness will persist beyond the end of the recession. Companies have cut the number of their employees and slashed other discretionary costs, such as advertising. This has significantly improved profit margins, even in the face of lower demand, but the higher profits are not coming from revenue growth but from lower costs, making it easier for companies to maintain or even cut prices rather than increase them.

Reduced spending by consumers and an extended high unemployment rate mean that we can look forward to a continuation of the output gap. This refers to the difference between the actual economic output and the most the economy could produce given the capital, know-how, and people available. That gap today is estimated to be between 8 and 10 percent, the largest on record. It makes for intense competition for scarce sales and jobs and results in continued downward pressure on prices. 

It will take a long time to absorb the enormous slack of unused labor and production capacity created by the deepest recession since the 1930s—and it ain't really over yet. In the meantime, the labor market is showing a continuing decline in wages and in average hours worked per week (now down to 33 hours, the lowest in 60 years), suggesting it will be a long time before labor markets are strong enough to push up hourly wages and income.