Anirvan Banerji
While examining cycles in growth and inflation in diverse economies over the decades, we've found consistent patterns that hold up over time and across a variety of economies. Other patterns, of course, are country-specific. It's those consistent patterns, though, that give us the deepest insights into the nature of phenomena like business cycles, inflation and deflation.
Falling Inflation Pressures
The Historical Evidence
By definition, deflation is marked by falling prices, which is why July's decline in the consumer price index and producer price index led to deflation concerns. But falling computer prices, for example, don't worry most people. What would be problematic is the generalized and persistent deflation that, say, Japan has experienced in recent years. In fact, years ago, we developed a simple and well-tested hypothesis about long swings in the level of prices: They are associated with the relative length of business-cycle expansions and contractions. Periods when expansions are much longer than contractions witness inflation, and periods when contractions last longer than expansions show deflation. To test this proposition, we took a truly long view -- based on U.S. data starting in 1789. The results are compelling. The U.S. has seen three extended periods of generalized deflation over the past two centuries: from 1814 to 1843; from 1864 to 1896; and from 1920 to 1932. The rest of the time, the economy experienced inflation, with most prices generally rising. During all three deflationary periods, the economy spent more time in contraction than in expansion. In other words, on average, recessions were longer than expansions. During the four inflationary periods -- from 1789 to 1814, from 1843 to 1864, from 1896 to 1920, and from 1932 to the present -- expansions were longer than contractions. In fact, during the latest inflationary period, which started in 1932, the average expansion lasted more than five times as long as the average recession. In the chart below, the yellow bars represent the proportion by which the duration of the expansions exceeds the duration of contractions. (For example, a figure of 4.3 means that the expansions were 430% longer than the contractions, while a figure of -0.1 means that the expansions were 10% shorter than contractions.) The light green bars represent the average annual percentage growth in the CPI, and the dark blue bars represent the average annual percentage growth in the PPI.| Inflation, Deflation and the Relative Durations of Expansions and Contractions |
 |
| Source: Economic Cycle Research Institute |
The Experience Abroad
With this historical understanding of U.S. deflation, it makes sense that Japan, which has spent most of the past decade mired in recession, has experienced persistent and generalized deflation. On average since 1992, when the Japanese economy entered its first recession in 17 years, expansions have been 22% shorter on average than contractions. Also no surprise is Argentina, which has shown deflationary symptoms since the mid-1990s. It's no coincidence that it has spent most of this period in a deepening recession. Thus, two centuries of U.S. experience as well as more recent events in other countries illustrate that generalized deflation occurs when contractions last longer than expansions. At first glance, what looks like a contrary example is China after the Asian crisis in the late 1990s. At that time, its economy showed clear signs of generalized deflation, despite production caps and price floors in many industries. Yet real GDP growth was reported to be above 7% during this period. Most informed observers of the Chinese economy are well aware that Chinese GDP tends to be overstated -- not that this is exclusively a Chinese problem. But our finding that generalized deflation occurs only during periods dominated by contractions suggests rather startling insights into the probable size of this bias. In other words, the association of generalized deflation with persistent contractions suggests that actual Chinese growth in the period following the Asian crisis may have been grossly overestimated.The Current U.S. Outlook
In the current period starting in 1932, expansions have become far longer than contractions, more so than during any period in U.S. history. At the same time, consumer prices have increased at a faster pace than in any of the previous periods. Therefore, if we're about to enter a new deflationary era with long expansions and short contractions, it would be a unique experience in U.S. business history -- the first time such a combination has coexisted in more than 200 years. Today, the empirical evidence can't eliminate deflation as a potential threat. It does, however, suggest that deflation is unlikely in the foreseeable future unless the current combination of relatively long expansions and steadily rising prices is about to end. For that to happen in the U.S. over the next few years, we'd need to see persistent recessions punctuated by shorter expansions. This would be a clear reversal of the postwar pattern of long expansions and short recessions that have lasted less than a year on average. While the possibility of a series of longer recessions can't be entirely ruled out, it's probably not going to happen. While a recovery is not imminent, the monetary and fiscal stimuli already provided are quite likely to result in a recovery by next year. Sure, inflation is likely to keep heading lower for now. And in terms of near-term growth, things are likely to get worse before they get better. But a Japanese-style deflationary spiral? Not likely.
RSS
