It may be time to take deflation seriously

At least Narayana Kocherlakota didn't waffle about what he thinks.

The statement Friday by the Federal Reserve Bank of Minneapolis president more or less pounds his colleagues at the Fed for not being worried nearly enough about the specter of deflation. It's not just what the Fed is doing that's wrong, through the policy levers it can throw, but it's what the Fed is saying about the economy and its policy.

Talking now about raising interest rates eventually, he wrote, is a really bad idea. If it were up to him, he would keep alive the idea that the Fed would continue its extraordinary purchases of bonds, called quantitative easing, so long as the inflation rate stays below the Fed's target.

It's clear that for at least this Fed president, the threat of deflation looks very real.

It's still a bit jarring for those of us who are baby boomers to hear talk of deflation, as most of us came of age when the big problem in the economy was too much inflation, or an overall increase in the general level of prices.

But inflation hasn't been much of a problem for a while, and at least since the end of the Great Recession there's been talk about the risk of deflation. And if you think inflation is bad, wait till you live through deflation.

Falling prices for many of the things we buy is not inherently a bad thing. Productivity gains and technological change can drive down the cost of products or services, the notable example being computing power. The iPhone on my desk is far cheaper and far more powerful than the computer I bought a decade ago.

Falling prices can mean lower sales and profitability for businesses, leading to cutbacks and wage reductions for workers, who in turn cut their spending. And then with falling prices they put off buying the things they do need, assuming they are soon going to be available at cheaper prices.

The normal functioning of the debt markets also more or less stops, too. People with bonds get paid back in dollars that are worth more than the dollars they lent, enhancing returns even though the interest rate may be near zero. The reverse is true, of course, for borrowers. Each scheduled payment becomes progressively more expensive as the purchasing power of the dollar increases.

Very few Americans still alive can remember what it was like to live in a deflationary period, during the Great Depression of the 1930s, but there have been far more recent examples of a big market economy that experienced a long period of deflation, such as in Japan.

But deflation can occur even without being precipitated by a deep recession. And deflation has played a significant role in US history, including a period called "the Great Deflation" that lasted basically from just after the end of the Civil War in 1865 until the end of the century.

There was more than one reason for it, from the return to a strict gold standard after the sloppy financial practices of the Civil War era to improvements in productivity as the nation industrialized. For whatever the reason, prices just kept dropping, and that was before the Panic of 1893, a sharp and brutal depression.