Time to act now before deflation destroys the economic recovery

The economy has entered a recovery stage from the shutdown ordered by the government to control the spread of the coronavirus. Getting states to fully reopen is the top priority for a fast recovery. But no one seems to be paying attention to another restraint on growth at play across the country, which is deflation, or a steep fall in prices. That is happening even with all the Federal Reserve interventions to provide more dollar liquidity and its pledge to keep interest rates near zero for two more years.

Many Americans might think that if prices fall, everything will cost them less. In reality, deflation tanked the economy in the Great Depression, and it has not worked out that great for Japan in recent times either. Deflation shrinks an economy, slashes business profits, and hurts farmers because crop and dairy prices fall, ranchers because meat prices decrease, drillers because oil prices sag, and jobs because employers pull back.

What is indisputable is that prices have been falling at a dangerous pace. The personal consumption expenditure gauge, which tracks household and individual spending, fell at more than a 5 percent annual rate, as the Consumer Price Index plunged at a 9 percent annual pace in April. The Consumer Price Index decline was faster than for any month since 2008. The core Consumer Price Index, which excludes food and energy, fell for the first time since 1982. Prices continued to fall in May.

Commodity prices, which we have argued are the best daily indicators of monetary conditions, are signaling a convulsive downward price spiral. Despite the recent energy rally, oil prices have fallen by about 25 percent this year. While it reflects a rapid fall in international demand, the global shortage of dollar liquidity is adding to the pain in the energy industry. Almost all commodities have seen major declines in prices.

The Commodity Research Bureau Index is down by about 35 percent this year. In terms of commodity price deflation from the peak in the previous recovery, the recession today ranks as the second worst in history, with the Great Depression coming in third. Even though the coronavirus has taken its greatest toll on the United States, the exchange value of the dollar has shot up by 8 percent, hitting new record highs.

More evidence of deflation is seen in the yields on Treasury securities and bonds. Treasury interest rates are bumping along at record lows even with slight rises in rates over the last few weeks. The Federal Reserve personal consumption expenditure target inflation rate is 2 percent, and the market is betting that personal consumption expenditure inflation will average barely more than a third of that rate for the next five years.

Our alarm over deflation may be surprising to some. In addition to the federal funds rate at close to zero, Congress has voted for $2 trillion in new government spending with more to come. The Federal Reserve has raised its balance sheet by almost $3 trillion in less than three months. In normal times these actions would be associated with rising prices rather than falling prices. After all, inflation is too many dollars chasing too few goods. Are we crazy for saying deflation is the problem?

Many economists both inside and outside of the Federal Reserve claim to be worried about inflation. Economists whom we greatly respect, such as former Senator Philip Gramm and former Federal Reserve Governor Larry Lindsey, argue that there will be significant inflation after the recovery. If that will be the case, however, then we have to ask this question. Why are people buying up 10 year Treasury securities at 0.7 percent interest rates and 30 year Treasury bonds at less than 1.5 percent interest rate?

When economists forecast one thing and then the bond market predicts another, the bond market is usually right. With the entire Treasury yield curve trading at historic lows, the bond market is saying, “Inflation? Do not hold your breath.” The answer to this paradox of record government spending and record low interest rates with falling prices is that when the world panics because of a war, a terror attack, a financial crisis, or in this case a pandemic, everyone wants to be more liquid in dollars.

Foreigners have been panic buying Treasury securities. The velocity of money, or the rate at which a dollar is spent and respent in the economy, has plunged, like after the Great Recession over a decade ago. Terrified investors and families are hoarding cash as a risk free asset in turbulent times, and some are even burying dollars in their backyards.

Even with all that Chairman Jerome Powell has done, the Federal Reserve has been behind the curve in fighting deflation for at least two years. By ignoring market signals for monetary policy, which former Chairman Paul Volcker followed to kill inflation in the 1970s, the Federal Reserve indeed continues to asphyxiate the world economy by depriving it of the dollar liquidity that global investors are demanding. President Trump has been saying this for years, and his instincts have been right all along.

Trump is predicting a rapid recovery, but that is hard to see, if prices do not stabilize. We are not arguing for another federal spending binge, as such spending misallocates resources and crowds out private investing and production. We cannot think of a worse idea than taking money from private producers and directing the funds to state and local governments with no accountability for how such taxpayer dollars are spent. We do not favor negative interest rates, which are a surrender to deflation.

One smart policy to pump dollar liquidity into the economy would be to suspend the payroll tax on employers and employees until the end of the recession or deflation. The Federal Reserve should reduce the interest rate that it pays on bank reserves to zero. The White House could also require federal agencies to pay contractors more quickly to increase the velocity of money. The economy is thankfully starting to show signs of recovery from the coronavirus downturn. To really get things rolling, the Federal Reserve and the Treasury Department must wipe out deflation.

Stephen Moore is a founder of the Committee to Unleash Prosperity and current member of the White House economic recovery task force. Louis Woodhill is a senior policy fellow at the Committee to Unleash Prosperity.