Is the US economy headed towards Japanese styled deflation? This is the worrying question doing its rounds in the economic intelligentsia. The very thought of deflation invokes discomfort as it made the Japanese economy sluggish for years together. But just what the hell is deflation? Deflation is an overall decrease in the general price level of goods and services in an economy. It should not be confused with disinflation, which is just a decrease in the rate of inflation. Deflation is a negative rate of inflation or a sub zero level in which, the value of money increases and consumers can actually buy more for their money than they could before deflation set in. Effectively, deflation increases the purchasing power at the hands of consumers for the money they have. Hmm! More goods for my money! That doesn't sound bad at all, then why such a hue and cry about deflation.
The problem with deflation is the trigger which leads to deflation. Deflation usually occurs due to a fall in the aggregate demand in the economy, which gradually leads sellers to drop prices of existing inventories to get rid of their over stocked positions. Lower demand leads to capacity utilization falling below optimal levels and signals a cut down in investment. The result is that the economy starts to slow down, and the industrial, and business activity, and the economy sink into a low growth cycle. To get an economy out of such a dilemma, interest rates can be lowered and government spending can be increased. But, how does one achieve that when, interest rates are already close to zero levels and government spending/fiscal stimulus is overleveraged. Deflationary periods also tend to commence after periods of economic depression and recessions, which have led to interest rates being lowered and fiscal stimulus being applied. Thus, deflation can naturally result after recession.
Deflation led contraction in business activity further leads to reduction in employment and consumer sentiment. Thus a vicious cycle sets in, with a dilemma for the government on how to exit such a deflationary cycle. Inflation in the US is subdued at this point of time. A gentle rate of inflation is usually suggestive of a healthy economy as the slight amount of excess money in the economy leads to firm demand for goods and services, which in turn encourages investment and employment generation. Deflation does just the opposite.
The condition of the US economy does point towards a weakening economic cycle. Home sales are in a slump, consumer confidence has ebbed, industrial growth is refusing to pick up, and employment numbers not picking up. Core inflation, which does not include volatile price items, reached its lowest since 1996! These eventualities lead to the question if the writing is on the wall!
So if such a situation is anticipated for the US economy, just what are the remedies that could be exercised? A key US fed official has suggested that the Fed buy US securities in order to release more money in the economy. This could technically work, but confidence in the economic process and consumer sentiment are a key for this, which requires more money in the hands of the consumers in a sustainable way. Thus, employment generation, investment etc., are important and just quantitative easing by itself may not be very helpful.
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