Will the Great Recession lead to Deflation?

We have all seen the effects of deflation – or falling prices – with respect to technology products, particularly in computer prices. Computer hardware and peripherals (personal computers, laptops, monitors, etc.) keep getting less expensive each year. Not long ago, the average price of a PC was about $3,000.[1] Today, you can purchase a much more capable computer with more memory and faster graphics for less than $1,000. With the velocity of change and improvement in speed and capability, today’s product could be outdated in six months. Now the consumer is faced with the following dilemma: buy today and get locked into a product that could be obsolete in six months, or wait six months for that same product to cost half as much.

The prices of consumer goods, especially electronics and computer-related products, have been falling in relative terms for the last couple of decades. Technology has driven much of that cost reduction, through automation (removing the expensive human labor component of product prices); increases in efficiency (by using computers to minimize work flow costs, touch labor, and inventory); and the Internet (the reduction and/or elimination of distribution costs by selling directly to the consumer). All these effects have put downward pressure on product prices, at least for those types of products that can maximize these cost efficiencies.

Interest rates are currently at their lowest since the early 1960s – that’s more than 50 years. What drove interest rates so low back then is also what is driving interest rates low now – the availability of cheap products holding prices down across the economy. Interest rates are a reflection of inflation. Typically, the inflation rate reflects the interest rate, in that, as inflation goes lower, so does the interest rate. This is known as “Gibson’s paradox.” But when the interest rates go to zero, or near zero, what happens next? Could interest rates actually go negative, so that you would have to pay the bank to hold your money for you? That’s a “depressing” thought.

Former Fed Chair Ben Bernanke’s speech in July 2013 stated that because of the “constraint posed by the effective lower bound on short-term interest rates” (the federal funds rate has been at or near zero since 2008), the Fed has been able to “respond to economic developments” (fight deflation) by affecting interest rates “further out on the yield curve” (long-term interest rates).[2] What the Fed has done is purchase $85 billion worth of securities monthly ($40 billion in agency mortgage-backed securities and $45 billion in Treasuries) over a long time period (from September 2012 to the end of 2013, tapering off to zero by October 2014) to maintain economic stability and asset prices.

My response to the question “Will the Great Recession lead to deflation?” is an emphatic “No.” I believe that we have safely passed the danger zone of falling asset prices and deflationary pressures. Housing prices have recovered and so has the stock market. The extraordinary measures the Fed has taken since the crisis of 2008 have accomplished their goal of saving the economy from the brink of collapse. We can only hope that these measures have not created any unintended effects (like new asset bubbles or severe inflation) that could crop up in the future.

financial crisis - Great Recession

[1] http://www.freeby50.com/2009/04/cost-of-computers-over-time.html

[2] Speech by Ben S. Bernanke, Chairman Board of Governors of the Federal Reserve System, "The First 100 Years of the Federal Reserve: The Policy Record, Lessons Learned, and Prospects for the Future," at a conference sponsored by the National Bureau of Economic Research, Cambridge, Massachusetts, July 10, 2013

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