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Consumer Prices and the Coming Deflation Wave

If you asked the average person on the street whether they thought consumer prices going down is good news, most everyone would answer yes. It’s only natural for one to assume that a decrease in consumer prices will result in being able to purchase more goods at a lower cost. If that’s the case then why do most economic columns and journals talk about the risk deflation poses to the growth of developed economies?

 

Deflation is commonly described as a decrease in general price level. In more professional terms, one would instead define it as a decrease in demand for market liquidity. This means that on one hand market participants need less resources to make their purchases. At the same time it also means that companies have to sell their products for less. As a result the real value of savings grows even when said savings aren’t being invested. In a sense this is a risk-free yield one can gain without needing to do anything for it. Savings that merely sit in an account without being invested or spent on consumption are the very definition of a surplus. Another example of surplus is the excess of goods created, but not sold due to lower consumption. Companies try to cut losses by ridding themselves of stockpiles of unsold products at a lower price. The larger the surplus of unsold goods the more deflation pressure there is pushing prices down to the point where some experts are calling it a deflation spiral or a deflation trap. One of the potential consequences of this process is companies not being able expand production. If they don’t expand production then they won’t have to hire additional workers or invest. This would naturally lead to growth and development slowing down. A deflation environment or possibly even a protracted period of low inflation could lead to GDP growth declining. The worst case scenario would be the looming specter of a potential recession.

 

The above mentioned deflation would be the result of surplus in both capital and goods. When central banks notice the signs deflation on the horizon, they tend to try and preempt it by lowering interest rates and the risk-free yields of savings to encourage consumers to spend or invest their funds. One of the effects of lowering interest rates is a decrease in the value of a country’s currency. This also raises the relative price of imported goods thus raising consumer prices.

 

Last year the US economy’s explosive growth caused both wages and consumption to increase rapidly. Now, possibly due to the increased tariffs, it seems that this wave may be winding down. One of the immediate responses to the China-US trade conflict was a sizable increase in orders by US companies from their Chinese trade partners in an attempt stockpile goods before the tariffs go into effect. This spike in orders radically shifted trade balance in China’s favor. Now that the number of orders is starting to ebb, China’s GDP expectations changed for the worse accordingly. Retail sales have been dropping in the US as well by as much as 1.2%.

 

The current environment in the US is one that supports lowering inflation. This includes a strong dollar, declining consumption, record size stockpiles of products and a population incentivized to save by the high interest rates. The Fed and the current administration are certainly not on the same page which leads to them often enacting measures that counteract one another. The Fed’s statements make it clear that it’s not possible for them to maintain their current trajectory of interest rate increases. Although macroeconomic data trends are always subject to change, at this point nobody expects to see three to four rate hikes over the course of this year. One of the major factors that could affect these figures is retail sales. A single data point of decline can easily be called as an outlier. The report released in January for example included the government shutdown so it’s easy to justify the drop. The upcoming retail sales report on March 14th will include the month of January along with its extreme weather conditions, making it difficult to expect an improvement.

 

Deflation is not a US specific phenomenon. The EU for example is on a steady track towards deflation with its decelerating inflation trajectory. Each member state saw a decrease of 0.2% in inflation per month. Meanwhile in China the rate of price increases dropped from 1.9% to 1.6%. The three largest economies in the world all have to deal with low inflation. In terms of interest rates the EU has a 0% base interest rate while the US and China have 2.5% and 4.35% respectively. Among these regions China has the most reason to lower their interest rates. For one, it would further weaken the yuan against the US dollar to help them maintain their advantage in trade. It’s also an effective tool for combating the slowing GDP growth. These arguments suggest that central bank of China is likely to slash rates eventually. Meanwhile the European Central Bank has no choice, but to stick to their current rates. The only question remaining is what the Fed will do.

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