Thursday, June 18, 2009

The Other Side of Inflation

Wednesday's release of the Consumer Price Index, as I expected, didn't show any signs of mounting inflation. The monthly rise in consumer prices came in at 0.1 percent in May, after staying flat in April. That's about as close to static prices as you'll ever see.

In fact, looking at the year-to-year figures, the Consumer Price Index has fallen by 1.3 percent over the past twelve months. That's the largest decline in nearly 60 years. So rather than inflation, should we be living in fear of deflation?

In many ways, deflation is a bigger problem than inflation. Inflation tends to be an indication of the economy overheating, and causes terrible erosion in our purchasing power. But deflation is a sign of the economy contracting. Deflation causes businesses to get less for the products they sell, meaning they are able to pay fewer workers less money, meaning the economy can't get moving again. In many environments, inflation is the bigger problem. In an economic slowdown, deflation would probably be more hurtful.

Are we headed for deflation? As I said, the latest numbers show prices static rather than dropping. The Fed seems to agree. "The recent data on inflation shows that the risks of deflation, which entered the minds of many central banks around the world over the last 18 months," said Fed governor Kevin Warsh on Tuesday, "the risks seem to be significantly attenuated."

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