With the financial crisis now squarely in the rearview mirror, the global economy seems poised for a sustained—albeit historically anemic—upturn. But that doesn't mean Federal Reserve Chairman Ben Bernanke and European Central Bank President Jean-Claude Trichet can let the signs of a nascent recovery distract them from the looming dangers of deflation.
That prospect is more real than many care to admit. Core consumer prices, which strip out volatile food and energy costs, rose by a record-low 1.5% in February from a year earlier in the 30 countries that form the Organization for Economic Cooperation & Development. And Goldman Sachs (GS) economists see core inflation falling further this year, to about 0.3% in the U.S. and 0.2% in the euro area.
This disinflationary trend is driven by the slack built up during the global economic slump. The 1.9% growth in OECD economies forecast for 2010 still will leave their total output for the year 4.1 percentage points below potential. With that much excess capacity, companies will remain under pressure to cut prices to keep customers.
Policymakers have "gotten their eye off the immediate ball, which is deflation risk," says Joseph Gagnon, a former Fed official who is now a senior fellow at the Peterson Institute for International Economics in Washington. "It's misguided for anybody to be talking about exiting" from stimulus during the next year.
The investment markets are already showing signs of this weakened pricing outlook. The gap between yields on U.S. Treasuries and Treasury Inflation-Protected Securities (TIPS) due in two years, a good measure of the outlook for consumer prices, stood at 1.56% on Apr. 5, down from a high of 2.92% in June 2008.
Falling core inflation "suggests an on-hold type of stance [from central bankers] for longer than was presumed in the past," says Bill Gross, co-chief investment officer at bond giant Pimco. New York University economist Nouriel Roubini agrees. He sees major central banks "keeping zero rates or near-zero rates at least to the middle of next year." And some economists are pushing back their forecasts for when the Fed and the European Central Bank will raise their benchmark interest rates, now near zero and 1%, respectively, well into 2011.
As Japan has learned painfully over the past decade, deflation can be debilitating and difficult to reverse. Faced with falling prices for their products, companies are unlikely to expand or add workers. Meanwhile, consumers delay purchases, hoping for better deals in the future.
Central banks can't easily respond because falling prices and wages make it harder for companies and consumers to repay existing loans, reducing their willingness to borrow and spend more even when interest rates are low.
Signs of the loss of business pricing power abound. For example, Dow Chemical (DOW), the largest U.S. chemical maker, reported in February that its prices on products worldwide fell 17% in 2009. And core consumer prices in the U.S. climbed only 1.3% in February from a year ago, the smallest increase in six years. In the three months through February, they rose at an annualized rate of just 0.1%.
Some European nations are already flirting with deflation. In Ireland, consumer prices fell 2.4% in February from a year earlier on an EU-harmonized basis, the 12th consecutive monthly drop. They fell seven times in Spain and 10 in Portugal during the past 13 months.
While that may allow those economies to boost exports by making their goods more competitive, lower prices could hurt more than help by forcing up real wages at home and the cost of servicing debt, says Eoin O'Callaghan, an economist at BNP Paribas.
Global inflation also slid after recessions in the 1970s and 1980s. Bruce Kasman, chief economist at JPMorgan Chase (JPM), says what's different this time is the "prospect for record-low levels of developed-world core inflation during the first year of an economic expansion." That risks letting deflation take hold, with dire consequences.