Examining The Risks Of Deflation

Some members of the Fed recently cited the threat of deflation. Deflation — a general decrease in prices — should not be occurring during an economic recovery. In many ways, it is more worrisome than inflation.

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From NPR News, this is ALL THINGS CONSIDERED. Im Michele Norris.

For the past seven decades, prices overall have headed in one direction: up. But consumer prices are now barely rising at a rate of just 1 percent, and some fear they might actually start falling. Thats called deflation, and it's got at least one prominent economist worried. We'll hear from him in just a moment.

First though, Planet Money's Adam Davidson explains just whats wrong with prices that go down rather than up.

ADAM DAVIDSON: Ladies and gentlemen, I have an amazing investment opportunity for you. Give me $100 - just a hundred - and in one year, I promise it will be worth 93 bucks. We call it the deflation special.

All right, seriously, nobody is giving anybody a hundred bucks just so they can lose seven. Thats the opposite of an investment opportunity - which is precisely why economists and central bankers get terrified when they hear the word deflation.

Technically, deflation means that the prices of all kinds of goods and services keep falling, rather than what they normally do, which is rise. And deflation means that not just one investment, but all investments are worth less next year because the currency they are based on - like the U.S. dollar - is going to be worth less next year.

When there's deflation - especially persistent, high deflation - the very logic of investing in the future is destroyed. Why pay money to build a new factory or buy a house or hire an employee or go to school if the payoff will be worth less than the money you put in?

Imagine an economy where nobody invests in the future - it is grim. The Great Depression was the last time the U.S. had major deflation. Deflation, once it starts, is extremely hard to stop. Which is why the Federal Reserve is doing everything it can to prevent it - although all the tools used to prevent deflation, like increasing the money supply and keeping interest rates incredibly low, can cause another problem: inflation.

Now, central bankers tend to think that they can stop inflation more easily than deflation. So given the choice, theyll inflate.

Adam Davidson, NPR News.

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