COMMENTARY: THE PRICES ARE FALLING! THE PRICES ARE FALLING!
Deflation is the unicorn of economics: something rarely if ever glimpsed. With few exceptions, price increases have been the norm ever since the Depression.
But the unicorn lives. So far in 1997, wholesale prices for finished goods, excluding food and energy, are falling at a 0.7% annual rate. And the declines are pervasive. In the past year, the wholesale price of cars has fallen by 1.9%, with similar drops in goods from washing machines to lipstick. Businesses are paying less for computers, trucks, and supplies such as industrial chemicals. In fact, wholesale prices for both consumer durables and business capital equipment are both heading down. The last time that happened was in 1960.
NO DANGER. The U.S. may be at the beginning of a period where price decreases for many products become as common as price increases. That's troubling for some economists, who point out that deflation in the past has been associated with tough times.
But this time around, deflation signals positive trends. Profits and wages are up even as wholesale prices fall--a combination that can exist only because U.S. businesses are boosting productivity. And the trend has major benefits: Deflation will boost people's real incomes because consumers' purchasing power will grow, making wage gains go further. And over time, interest rates will fall as bond investors see that inflation is no danger.
How long can this deflationary period last? The latest figures show nonfinancial corporate productivity rising by a strong 2.9% over the past year. As long as these gains continue, companies can charge lower prices and still make money. Indeed, they may have no choice in a world of intense global competition.
Moreover, outside of high tech, there is simply not enough growth in the economy to ignite inflation. According to the latest data from the Federal Reserve Board, industrial production in 1997 is rising at a 4.1% annual rate, only slightly below 1996's strong 4.4% pace. But take out computers and semiconductors and the rate drops to 2.2%. That's down from a 3.1% rise in 1996 and well below a rate that will spark inflation.
The likelihood of deflation will grow as high tech takes a larger role in the economy. Consumers now spend $95 billion a year on televisions, stereos, and home computers--more than the $85 billion they shell out for new cars. Businesses spend more on high-tech gear than on industrial machinery. And with computer prices dropping 15% to 20% a year, the momentum for falling prices is enormous.
The shift to a deflationary economy will require a big adjustment by investors, businesses, and consumers. Deflation is good for lenders and bad for borrowers, who cannot count on inflation to ease their debt burden. This may help explain why personal bankruptcies have been on the rise despite low unemployment. Moreover, businesses have to learn how to function in an environment where waves of deflation sweep across the economy, hitting first one industry and then another.
It took time in the 1970s for people to accept the idea of persistent inflation. Now, we will find it equally hard to believe that prices can fall. But deflation may be here to stay.
By Michael J. Mandel
Updated June 23, 1997 by bwwebmaster
Copyright 1997, Bloomberg L.P.