Opinion | Deflation — Not Inflation — Is the Real Concern

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Between 1916 and 1929, there was a war followed by a pandemic and a financial crash. In the period 2008-2022, there was a financial crash followed by a pandemic and a war. Worryingly, in the period following the 1929 Great Crash there were years of depression, with unemployment rates as high as 25 percent and deeply damaging deflation. There is much to be learned, at the start of the 21st century, from what happened at the start of the 20th century. But policymakers are forgetting their history, and now they’re basically winging it.

Federal Reserve Chair Jerome Powell and his colleagues claim inflation is going to get stuck at some high level which has to be tackled by higher interest rates. They reassure us this has to be done, or the “pain” Powell is already vowing to bring will get worse. This is just what I call guessenomics, based on zero data. More plausibly this path leads to a hard landing with rising joblessness and an unnecessarily destructive economic recession. Incidentally, recent evidence suggests that a rise in the unemployment rate lowers well-being for the average person much more than an equivalent rise in the inflation rate. In fact, it is now time for rate cuts.

My concern is that Fed officials are wrong and what is coming is not high inflation again but a worrisome bout of deflation. So here is an explanation of what may well happen:

If Year 1 prices are at 100, Year 2 prices will rise to 110, which is a 10 percent inflation. Year 3 prices stay at 110, which is 0 percent inflation. But watch when Year 4 prices drop to 105: That would still be 5 percent above year 1 levels, but now we have 4.5 percent deflation. This is what has happened in Japan, with inflation moving back and forth into deflation.

The only reason inflation would rise again is with another shock. The Covid supply shock was ebbing away which made the Fed think inflation was temporary, but then another shock — the Ukraine war — gave prices a boost again. But now prices are headed down and inflation is temporary, unless another Covid shock comes along, say. And unfortunately, central bankers have little clue on how to fix deflation and the kind of depressed economy that follows.

The longest timeline on the path of inflation that exists anywhere is instructive. The data is downloadable from the Bank of England in “FRED” and shows Consumer Price Inflation for the U.K. since 1210. (The U.S. for age reasons can’t compete.) The chart shows after bursts of high inflation, it’s common to see years of falling prices. Deflation occurred in 340 of these years. High inflation is not usually followed by nearly as high inflation. Historically that doesn’t happen.

Oil prices have been sliding as have the prices of many commodities. An important signal of what is coming is the Baltic Dry Index, which collapsed in June 2008 ahead of that year’s economic crisis and is in freefall again. It is the daily price of renting giant ships called capesize vessels, which are too big to go through the Suez or Panama canals. Prices are announced at 10 a.m. daily on the Baltic Exchange in London; wheat and coal are dry, oil is wet. BDIY was 5600 in November and today it is 1100 and the cost of shipping containers has halved in 2022. None of this is a surprise given that China’s economy is slowing, with the lowest growth rate in 40 years and the Eurozone and the U.K. are already in recession. When global demand is falling, ships stop sailing and prices drop. Deflation is the fear.

To this point, the labor market has been quite resilient but in the latest BLS jobs report the unemployment rate ticked up from 3.5 percent to 3.7 percent and much more for marginal workers who are the first to be hit in a weakening labor market; unemployment rates rose 0.4 percent for African Americans and by 0.6 percent for Hispanics and high school graduates. Those who do best in the boom do worst in the slump: last in first out, probably with worse to come soon.

The U.S. entered recession in December 2007 but even by the collapse of Lehman Brothers in September 2008, the Federal Reserve and Chair Ben Bernanke were taken by surprise. They all missed it together as the world economy went into free fall.

I saw firsthand how groupthink consumes central bankers when I was a member of the interest rate setting committee at the Bank of England from 2006 to 2009. I started voting for rate cuts in October 2007 for fear of the recession that I saw coming and continued to do so for a year — all alone. I was the sole dissenter. The U.K. entered recession in April 2008 and the others on my committee finally joined me in October 2008; soon we were cutting rates like gangbusters and eventually pursuing lots of quantitative easing to support the economy. Those who missed the looming recession said nobody should have expected them to see it coming (because they didn’t) and even if they had, it wouldn’t have made any difference. It would have.

The consensus today at the Fed is rates in the U.S. have to be raised to prevent the possibility of a wage-price spiral as occurred in the 1980s. But there’s no chance of that: Real wages are falling sharply. Then-Fed Chair Paul Volcker stepped in and raised interest rates through the roof to deal with “cost push” inflation. The relevance of that period is hard to see. At the time, union membership around the world was dramatically higher having risen strongly in the 1970s. In the U.S., powerful unions were able to negotiate Cost of Living Adjustment (COLA) clauses in contracts which meant pay raises ticked up mechanically if inflation was above a set amount. That world has disappeared into the ether. Unionization has collapsed globally and there is zero chance of a wage-price spiral; nobody has COLAs and wage growth remains weak. A wage-price spiral now is most unlikely.

In these very uncertain times, it is surprising how much central bankers at the Federal Reserve are all reading from the same playbook. Surely, they cannot all think the exact same. And their approach does not inspire confidence given they previously missed the biggest financial crisis in 80 years. There is no point having a committee if everyone is content to be wrong together. Groupthink is what makes organizations fail and they are at it again. Ordinary people will face the consequences.

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