As if Great Depression-size job losses and a cartoonish contraction in the nation’s economic output weren’t enough, analysts are starting to fret over a new risk from the coronavirus pandemic: deflation.
Deflation, or a sustained period of falling prices, may sound like a good thing: Goods and services cost less, saving consumers money. But deflation prompts shoppers to put off purchases on the expectation that prices will fall further if they wait. That can lead to a toxic cycle in which lower spending prompts businesses to cut wages, further pushing down consumer purchases and prices.
Deflation also can make it harder to repay mortgages and other debt, which become costlier in inflation-adjusted terms.
The economy can get stuck in a rut, similar to the “lost decade” that battered Japan in the 1990s.
Economists similarly worried about deflation during the Great Recession of 2007-09. But while average annual price increases dipped below 1% in 2010, they never declined. The current recession, however, has featured a more abrupt and dramatic blow to the economy.
“I think the risk of the U.S. falling into a deflationary trap is higher now than at any time during the Great Recession,” says economist Ryan Sweet of Moody’s Analytics.
The U.S. is not now experiencing deflation. Sure, oil prices have cratered to historically low levels and gasoline prices are slowly following them down. But when assessing deflation, economists generally put aside food and energy costs, which are highly volatile and likely to recover from near-term ups and downs.
A measure of prices excluding food and energy costs that the Federal Reserve watches closely – known as the core personal consumption expenditures (PCE) price index — rose 1.7% annually in March, below the Fed’s 2% target but nothing close to a yearly decline. Yet the shutdown of much of the nation’s economy to contain the coronavirus – along with more than 20 million related layoffs – has hammered consumer demand.
In response, airlines already have slashed ticket prices. Hotels are expected to follow suit, Morgan Stanley wrote in a research note. In March, apparel prices were down 1.6% annually and new vehicle prices fell 0.4%.
Perhaps a bigger concern is that the sudden drop in consumer spending, amplified by the layoffs, has hammered business revenues, forcing many companies to lower wages at least temporarily, says Barclays economist Blerina Uruci.
A myriad of companies have announced executive pay cuts, including Delta, Marriott, Macy’s, Bed Bath and Beyond, Nordstrom and Macy’s.
Many small businesses are also reducing wages for low- and midlevel workers as sales have plummeted. Creative Noggin, a marketing company in Boerne, Texas, has trimmed salaries across the board by 20% to 30% rather than lay off any of its 14 employees, says CEO Tracy Marlowe.
Lower wages can further dampen consumer spending, forcing additional price cuts, Uruci says. Reduced pay, she says, also gives business more room to lower prices and maintain at least modest profits.
During the Great Recession, by contrast, most businesses didn’t cut wages despite unemployment that hit 10% because they didn’t want to lose their most skilled employees, Uruci says.
Barclays expects the rise in the core PCE index to average 0.6% from the third quarter of 2020 through the first quarter of next year. That’s a meager price rise but it’s not deflation. And Sweet says he would need to see price drops persist for more than six months to label the episode deflation.
Morgan Stanley says certain bonds that hedge against inflation are implying a 55% risk of deflation over the next two years, but the research firm says the market is far overstating the chances.
The Fed is doing its part to head off deflation by making clear it will do what it must to spur stronger demand and higher prices by lowering borrowing costs.
“As long as inflation expectations remain anchored, then we shouldn’t see deflation,” Fed Chair Jerome Powell said at a news conference last week. “Needless to say, we’ll be keeping very close track of that.”
But with inflation expected to fall to such low levels in coming months, it wouldn’t take much to push the economy into a deflationary spiral, Sweet says. After all, long-term forces such as discounted online shopping and the more globally-connected economy have been keeping inflation below the Fed’s target for years.
Now, many states have started to allow shuttered business to reopen and a solid recovery is expected by summer, assuming the outbreak eases substantially by then. But if that doesn’t happen, or if the virus returns to a significant extent in the fall or winter, that could halt the rebound and increase the chances of deflation, Sweet says.
“We can’t afford anything else going wrong,” he says.
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