The Threat of Core Deflation!
The Fed’s job is not to look out for the interest of savers. That’s the free competition of the market, some will make optimal investment decisions and some will not. The Fed isn’t supposed to try to handicap the different groups to make the investment market “fair”…. The Fed has two jobs – and only two jobs: To protect the U.S. dollar from runaway inflation, and to protect the U.S. dollar from core deflation. They have an unofficial goal, or target, of 2% inflation per year… but honestly there’s no real problem with inflation levels that range between 1 and 4%. It’s when inflation rates start climbing towards double-digits that your economy is headed towards a complete mess that might take a full decade to straighten out (for the U.S., that was our late70’s and early 80’s). But an equal – if not greater – fear is CORE DEFLATION.
Deflation is roughly the economic equivalent of an atomic bomb. No matter how well the economy is doing, a state of deflation will rapidly suck the economy into a chain reaction of continual contraction. Here’s how it works: We’ll use vehicles as an example, though any example outside of entertainment (this includes most electronics) and consumable needs applies here.
Let’s say the auto industry is facing deflation (the why is irrelevant here – let’s say it’s from a new overly aggressive competitor who’s willing to sell at a loss to get greater market share, and is therefore pushing down the prices of its competitors… or make up whatever alternate story makes you happy.)
Now that the industry is in deflation, consumers start to notice that every month they delay purchasing a vehicle, the cost goes down. The natural reaction for some families WILL be… Delay. Regardless of any other factors, out of every hundred couples who are interested in buying a new vehicle, a few will decide to pay down debt and stick with their current car for a few more months until the market finds a floor…
Some percentage of vehicles will be unsold, because the consumers noticed deflation. This leads to two things: Excess inventory and decreased orders for more inventory. The manufacturers start cutting hours and furloughing workers (or laying off workers, depending on whether the workers are unionized), and the car lots start having sales and other promotions.
The families that delayed are now seeing a further drop in prices, and more families are noticing the drop in prices and noticing that delaying their purchase might save them money…and many families who have people in the auto industry now have less money, and so must delay a new car purchase.
Next: Now there’s even more excess inventory, which leads to more layoffs and cost cutting, and deeper sales prices and further promotions…
Now this cycle can hit any particular industry pretty hard, and it will take a period of winnowing the field, and a period of slow degradation of the product that was deflating… but in many cases the market corrects itself eventually because all those people delaying their car purchases eventually just need new cars. (To look at an example of an industry hit by deflation, discuss the past 9 years with someone who worked in the housing industry or residential construction). But in the case of core deflation, a majority of industries are undergoing deflation at once, and delay not only saves money on a single purchase, but the money saved becomes more valuable for all purchases. While one family is delaying their car purchase, another family is delaying a new furniture set, and a housewife is delaying the purchase of shoes or a new wardrobe, etc… So now there’s layoffs in dozens of industries at once, with families from dozens of industries all cutting back on expenses and paying down debt – which means the collective debt of society as a percentage of GDP drops, further strengthening the currency and causing more deflation…
There’s no real telling how deep such a rabbit hole might go. We have lived with modern means of keeping deflation at bay for so long that the threat has largely been forgotten or ignored in industrialized societies that have central banks – because it’s well understood that no central bank could ever be stupid enough to not intervene through some inflationary act (usually by cutting interest rates).
I’ve used the term “core deflation” here because this process doesn’t work well with energy or food. The term “core inflation”, or “core CPI” is the inflation of all goods and services except for food and energy. If the price of gasoline is dropping week by week, you might wait until the tank is absolutely running on fumes before filling up, but you aren’t going to just keep putting off your gasoline purchase indefinitely. The same goes for food. If food is dropping in price you might eat down everything in the pantry and freezer before making your way to the grocery store… but you aren’t going to go on a hunger strike until food prices find a floor. You’re going to eat – and so will everyone else. So in consumable goods the deflationary cycle doesn’t last long.
Articles that have cited this explanation:
Quit calling for the Fed to raise interest rates already!