By Michael Johnston
NEW YORK (
) -- First, the good news: Fears about runaway inflation appear to have been overblown. Now for the bad news: The opposite may be worse.
For months, wary investors have been eagerly watching consumer price index (CPI) reports. But instead of racing toward the double digits, inflation has slowed. That has sparked fears of deflation, a rare but serious economic condition that has some of the world's most prominent investors concerned.
Mohamed El-Erian recently told
that the U.S. faces a 25% chance of deflation and a double-dip recession. Jan Hatzius of
, another in a growing group of "deflationistas," sees CPI increases near zero in the near future and views a decline in prices as a real possibility. Hatzius says the tremendous amount of spare capacity in the U.S. economy will make it difficult for companies to raise prices, thereby increasing the risk of deflation.
Deflation can be devastating. When prices are falling, consumers are likely to delay purchases, waiting for costs to slide further before making a cash outlay. In a deflationary environment, sitting on a pile of cash becomes an attractive investment option with a positive real yield; the prospect of investing that money becomes rather unappealing. Moreover, borrowing money becomes undesirable because any loan will have to be repaid in dollars that are worth more than the dollars borrowed.
There are other reasons why deflation is disliked. Falling prices increase the burden of debtors. Finally, when prices are falling, wages often decline, too, either in the form of nominal cuts or upticks in unemployment.