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The Specter of Deflation

It's a dangerous problem, but it usually occurs only in periods dominated by recessions.

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Six straight quarters of GDP growth have demolished the double-dip demon's credibility. With the clearing of the fog of war, it's also evident that the risk of a new recession has dropped sharply. While some observers are still waiting for more data, the reality is that we already have enough to make a call.

The growth rate of the

Weekly Leading Index published by the Economic Cycle Research Institute, which correctly predicted the last recession, had risen to a 45-week high by late May, suggesting that a new recession is very unlikely.

But the "perfect" V-shaped recovery remains a fantasy. With business spending and hiring unlikely to surge anytime soon, the recovery will probably remain subpar.

The Deflation Dragon

The new enemy is deflation. To listen to some learned economists and policymakers, you'd think that the deflation dragon is already breathing down our necks. According to one poll, the majority of the general public already believes that.

The key parallel driving these concerns is Japan, where the popping of the 1980s asset-price bubble brought economic malaise and deflation in its wake. These concerns were telegraphed a year ago by a

Federal Reserve

paper attempting to draw lessons from the Japanese experience, concluding that in hindsight, the Bank of Japan had been too tight.

More recently, the research director of the Dallas Fed put the chances of U.S. deflation at one in four, arguing that because it's happened here before, it can happen here again. The International Monetary Fund has warned of a liquidity trap, where even if more money is printed, demand falls as people hold on to money in the expectation of lower prices. Last weekend a noted

New York Times

columnist added his voice to the chorus, opining that the risks of a deflationary quagmire "look uncomfortably high."

But all of this learned analysis seems to have missed a key piece of the puzzle when it comes to the circumstances that lead to deflation. And that's the role of recessions. Contrary to much that has been written, the history of deflation in both the U.S. and Japan shows that it's not slow growth per se but frequent recessions that are associated with deflation.

The Role of Recessions

Some years ago at ECRI, we studied the history of deflationary episodes inthe U.S. Since the late 18th century, long periods of falling prices havealternated with extended periods of rising prices in the U.S. economy. As I

discussed in August 2001, we found that in every deflationary period since 1789, the U.S. economy spent more time in recession than in expansion. In every inflationary period, the opposite was true.

The Japanese experience in the 1990s is consistent with this pattern. After the pop of the 1980s bubble, the Japanese economy kept growing for two years before contracting from April 1992 to February 1994. In the wake of that recession, the consumer price index declined by 0.8% from November 1994 to October 1995 as a surging yen fueled import price deflation. But then, for the next three years, the CPI rose.

That isn't surprising. After all, during the three years after the 1992-94 recession, the Japanese economy actually grew, with GDP rising at a 2.8% annual rate, industrial production at a 4.4% annual rate and personal income at a 1.8% annual rate. By 1996, employment was growing again, and the jobless rate had begun to decline. In the wake of that recovery, the brief appearance of mild deflation quickly gave way to rising prices.

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But then, disaster struck. The Japanese government decided to raise the sales tax from 3% to 5% effective April 1, 1997. In anticipation, consumer sentiment plunged to a 23-year low in the fourth quarter of 1996, contributing to a sharp drop in ECRI's Japanese Long Leading Index by late 1996, signaling a new recession.

The government was oblivious of the danger, as indeed was the business community. Even as late as June 1997, three months into the recession, ECRI had to defend its recession call against the respected Tankan index of business confidence, which had risen to a five-year high. This recession, undeterred by any timely policy response, sealed the fate of the Japanese economy. But this was hardly inevitable without the jolt of the 1997 tax hike.

In November 1998, 20 months after the recession began, deflation began in earnest, and that downturn in prices has not yet ended.

Consistent with the finding that deflationary periods are associated with more time being spent in recession than in expansion, it's telling that since 1992, Japan has spent 60% of the time in recession. The first recession lasted from April 1992 to February 1994, the second from March 1997 to August 1999, and it's still premature to identify the end date of the third, which started in August 2000.

But before the second recession, triggered by the sales tax increase, the economy was expanding, and prices were rising. It is not until nine years after the popping of the asset bubble --

and only after a second back-to-back recession ensured that the economy had spent more time in recession than expansion

-- that true, sustained deflation began, with falling prices contributing to falling demand.

This is not to suggest that tight monetary policy did not foster Japanese deflation. But it's a mistake to compare superficially the U.S. economy with the Japanese economy without appreciating the crucial contribution of repeated recessions to deflation.

Repeated Recessions: The True Hazard

The April drop in the U.S. CPI gave fresh lease to deflation concerns, especially because "core" CPI inflation, which excludes food and energy, fell to its lowest reading since 1966. But actual deflation was visible only in tradeable goods, the result of the massive overcapacity created by the first global recession in a generation.

It's a truism that recession kills inflation. Thus, the 2001 global recession, coming when the world's major central banks had achieved virtual price stability, depressed the prices of tradeable goods affected by the global overcapacity. The outcome was a massive shift in mass manufacturing capacity to China, increasing deflationary pressures.

But there's no deflation in services. In fact, the CPI for services excluding rent, which accounts for about 28% of the CPI, is now rising at a 5% annual pace. Inflation in the CPI for rent, which accounts for about 31% of the CPI, has dropped to a 1.9% rate from a 4.4% rate last year -- in part, the paradoxical side effect of the rise in home ownership caused by falling mortgage rates. This is partly why "core" inflation has dropped in recent months.

But true deflation, characterized by a broad-based fall in prices accompanied by declining demand, is nowhere in sight. Even a temporary drop in the CPI driven by falling prices in some categories wouldn't be a sign of real deflation. In fact, the pernicious deflation that central bankers fear is not a serious threat at this point.

Of course, the recovery is likely to remain subpar for now and could use some stimulus. The Fed achieved that objective this month by using deflation talk to scare the bond market, thus lowering bond yields. The drop in yields on U.S. bonds relative to the eurozone also helped weaken the dollar, which should help U.S. exporters. In effect, the Fed managed to provide effective economic stimulus by talking rather than doing, while keeping its powder dry for use in a true emergency.

Real deflation is a dangerous disease. But history, in both Japan and the U.S., shows that it occurs in periods dominated by recessions. And according to ECRI's leading indicators, a new U.S. recession isn't on the horizon. If that changes, I'll start worrying about deflation.

Anirvan Banerji is the director of research for the

Economic Cycle Research Institute, which was founded by Dr. Geoffrey H. Moore, creator of the original index of leading economic indicators (LEI) for the U.S. Department of Commerce. Banerji is on the economic advisory panel for New York City, and is also a member of the OECD Expert Group on Leading Indicators. At time of publication, neither Banerji nor his firm held positions in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Banerji cannot provide investment advice or recommendations, he welcomes your feedback at

Anirvan Banerji.