The deflation monster

There has been plenty of talk among Fed officials and financial pundits about deflation and the danger it poses to the economy. But what is deflation and why is it so scary? First, let’s define the term. Just as inflation is viewed as a general rise in the overall price level, deflation is the opposite – a general decline in prices.

Imagine renewing season tickets to your favorite sports team and paying less than the prior year or getting an upgrade for the same price. Or sitting down at a restaurant you frequent and being handed a new menu with lower prices. At first glance, it sounds like economic nirvana! Let’s be honest, who doesn’t like paying less?

But a general drop in overall price level has its dark side and could turn a severe recession into another depression. If falling prices take root in the economy, consumers would likely hold off on some purchases, further exacerbating the decline in economic activity. And businesses, faced with falling sales and profits, would respond by further slashing payrolls and/or cutting wages.

However, debt outstanding would remain intact and declining payrolls, combined with lower salaries, would likely push debt-strapped consumers further behind and into default. That would add pressure on an already-fragile banking system.

You can see how a downward spiral might get out of control.

Consequently, this economic scenario, which is akin to an economic black hole, is something the Federal Reserve and Fed Chairman Ben Bernanke are trying to avoid at all costs.

As many of us already know, wage growth has slowed considerably. But commodity prices, which virtually fell off of a cliff late last year, have edged off recent lows, while crude and gasoline prices have rebounded modestly.

Plus, the rate of deterioration in the economy appears to be slowing. Unless the rapid decline in economic activity continues, and the odds of this happening are starting to recede, the risk of deflation seems remote.

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