Deflation - Should The Fed Be Worried?

One of the greatest fears of central bankers around the globe is deflation.  While most of us that consume would consider a drop in prices to be a good thing, the great minds at the Federal Reserve and its peers around the world think otherwise.  From a central banker's perspective, there are two main problems with deflation:

1.) If prices fall, people are less willing to spend since they expect the price of whatever they are purchasing to be lower in the future.  This means that they are less likely to borrow to fund their delayed purchase.  Think of it this way; when prices are falling, sitting on cash results in a positive real yield on your "investment".  Dropping prices result in slower economic growth, creating a deflationary trap.

2.) If deflation occurs and prices fall, the cost to service debts rises because the debt will have to be repaid in dollars that are worth more than the dollars that  were borrowed i.e. the real (inflation corrected) burden of the debt increases.  This is exactly opposite to the current situation in the economy; if you borrow a dollar now, inflation pushes its real value down in the future, making it cheaper to service the debt.  

3.) If deflation occurs and prices drop, wages tend to fall as well.  While wages normally behave in a rigid fashion as shown in this paper because of minimum wage laws and unions, in a contracting economy, wages will fall in a deflationary environment, putting further downward pressure on consumption levels.  

A 1930s paper by Irving Fisher about debt-deflation attributed the Great Depression to the bursting of a credit bubble which resulted in an economic cycle that progressed as follows:

1   Debt liquidation and distress selling.

2   Contraction of the money supply as bank loans are paid off.

3   A fall in asset prices.

4   Dropping net worth of businesses 

5 Rising bankruptcies.

6   Dropping profits.

7   A reduction in trade, economic output and employment.

8   A loss of confidence.

9   Money hoarding.

10   Falling nominal interest rates  

11 Rising deflation-adjusted interest rates.

Does any of this sound familiar?

To give you a sense of how bad deflation was during the Great Depression, here is a graphic from Irving's paper showing how U.S. wholesale and retail prices dropped during the early 1930s:

Now that we have that background on deflation, let's look at the evidence that shows why the Federal Reserve should be concerned about deflation.  For the purposes of this posting, I will look at the import price indices for four of America's largest trading partners; China, Japan, Canada and the European Union.  Here is a graph from FRED showing the import price index for all commodities imported into the United States from China since the beginning of the Great Recession:

Notice the downward slope from the end of 2014 to the present?

Here is the same data showing the year-over-year percent changes:

Basically since late 2012, the import price index for America's largest trading partner has been in negative growth territory. 

Here's the import price index for all commodities from Japan:

Once again, note the decline from the end of 2012 to the present.

Here's the same data showing the year-over-year percent changes:

Here is the import price index for all commodities from Canada, America's second-largest trading partner:

Again, note the decline in the price index since July 2014.

Here is the same data showing the year-over-year percentage changes:

Since Canada exports a significant amount of oil and natural gas to the United States, both of which have seen significant price declines since mid-2014, it is important to look further into the Canadian economy for other signs of export deflation.  Here is what has happened to the price index for non-manufactured articles:

....and manufactured articles:

Lastly, let's look at what has happened to the import price index for Europe:

Again, note the decline in the import price index that has occurred since mid-2014.

In late 2015, China displaced Canada as America's largest trading partner.  The developing situation in China's economy is creating one significant new export; deflation, a contagion that is going to impact the U.S. economy.  Here is a graphic showing China's GDP deflator which now sits at minus 0.5 percent:

China's significant problem with overcapacity is putting downward pressure on global prices which could result in global deflation, a problem that will likely keep central bankers awake at night as they try to reflate the economy.

So much for all of that "printing" that has gone on since 2008!