Statistics out today on inflation point to exactly what I’ve been lately saying–the US is entering a period of declining prices due to declining demand.  The consumer price index (CPI) was down a tenth of a percent this month (-0.1%) and is flat year over year.  The producer price index clocked in at half a percent lower (-0.5%), for its third consecutive monthly decline.   This is not deflation, as all the pundits–even well-respected ones–will say, but is the result of declining demand.  The effect is similar, i.e., both deflation and declining demand yield declining prices.  But the prescription for one is just the opposite of that for the other.

Declining prices are perfectly natural during an era of oversupplied demand, and oversupply is endemic.  For example, take two signal industries in the US–housing and automobiles–comprising a total of roughly ten percent of gross domestic product.

Domestic auto sales, although increasing a bit this month, have declined from a high in 2006 of over 20 million annual sales to a level now of about 12 million per year.   Domestic sales hit their all-time peak in the fourth quarter of 2001 as automobile manufacturers stimulated post 9/11 demand with zero interest rate promotions (instead of decreasing the sticker prices, as I’ve discussed before).   A quantity-sold decline of roughly forty percent over four years should be all the evidence one needs in order to conclude that demand in the automobile market has declined.  If prices and supply have not appropriately declined along with demand, government intervention of one sort or another is to blame. 

Then there’s housing.  Everyone knows the tale of housing, that got, like the domestic automobile market, a monetary boost due to the Fed’s expansionary, low interest rates after 9/11, and several more boosts along the way until by 2003, interest rates were lower than they’d been in forty years.  Now that all the excesses of monetary expansion have come home to roost, i.e., we’ve experienced the temporary expansion in demand due to illusory price signals which has since burst, is demand declining in the housing market?   Well, yeah.  Alot.

Existing home sales, even with mortgage rates at all-time lows, fizzled just as soon as the $8,000 tax credit expired, declining another 5.1% in June from May’s 30.0% decline.  New home sales are even more dismal, at the lowest levels of all time, in data going back to 1963.  (There were roughly three-quarters as many people in the country then as now.)

The percent of housing stock that is vacant has increased from about 1.8% in 2006, before the crash, to a rate of about 2.5% today.  The percentage of rental housing that is vacant has also increased, from about 9.6% in 2006 to 10.6% today.  People are leaving more housing to sit empty as they consolidate households.  The  demand for housing has declined, and is declining.

So what is a central bank to do? 

Nothing.  Absolutely nothing.  Any monetary machinations will only make things worse.  The cure for declining demand is declining prices, and declining prices need time to work their way through the economy until such time as they get low enough for demand to grow and the economy to expand.   There will be pain–mostly in the banking sector through declining asset prices plowing holes through balance sheets–but there will be pain whether or not the Federal government or the Federal Reserve does something, and the act of attempting a solution will distort the price signals that would quickly resolve this conundrum.

What will be done? 

Quantitative easing is being shouted from the rooftops of all the supposed experts as the prescription for this declining-demand economy.  From Federal Reserve Bank Presidents to policy wonks at the American Enterprise Institute, the consensus is that the decline in prices must be arrested and reversed through profligate money creation.  This bias against declining prices, this belief by all concerned parties that declining prices indicate deflation, is utterly wrong.  Deflation is a monetary phenomenon that occurs when money becomes relatively more valuable than the goods and services it is used to represent.  It can be solved by  monetary prescriptions, namely, by simply increasing the money supply.  This episode of declining prices is not deflation.  It is the result of declining demand.  A monetary prescription will not cure it.

 Ironically, the Fed and Fed watchers created the trap in which they find themselves by expanding the money supply so drastically until oversupply in practically everything became endemic; now they wish to use the same strategy that got them here to get them out again.  It won’t work.  In fact, it will further worsen oversupply, if of a lesser magnitude than before–monetary prescriptions are not unlike doctor’s scrip’s–they lose effectiveness after a time and after repeated dosages.   A harder crash awaits in the breech.

It is high time we quit believing a wizard behind the curtain can turn a few monetary screws and make all things right with the economy.  It simply isn’t the case.  Money’s most important function in an economy is communicating value through the price signal.  It is part of an economic system’s communication infrastructure.  The signals it sends can get garbled through mismanagement of the infrastructure–whether by providing more money or less than is generally needed to accomplish the price and value communication function.  But that’s all.  Intentionally distorting the pricing signal impairs its value as a communication medium, and ultimately always fails to achieve the intended results.  The message will get through–prices wish to fall–no matter how much tinkering is done with the infrastructure used to deliver it. 


Calculated Risk Blog

Bureau of Labor Statistics

National Association of Realtors

U. S. Census Bureau