Why Those Dropping Gas Prices May Not be a Good Thing
|October 27, 2008||Posted by Roshawn Watson under Uncategorized||
By: Roshawn Watson
Prices for a number of items have finally started to decrease, but could prices be decreasing for the wrong reasons? To most over-stretched consumers such a question may seem preposterous. Many Americans are struggling to pay for housing, food, gas, and other necessities and still licking wounds from decimated portfolios. The idea of prices deflating may sound somewhat comforting and even attractive. However, many economists are sounding the alarm about a growing new economic concern: the damaging effects of price deflation.
Image Credit: Clan
Aren’t Prices Just Correcting?
Perhaps it is just me, but I thought “price correction” was a good thing. Our prices have been so inflated that even buying the essentials was becoming a stretch for some (i.e. gas, food, and housing). It seems only natural that prices would have to correct themselves at one point.
While it is true that deflationary periods certainly start off as “price corrections,” the bigger concern is stopping the prices from dropping. Once the deflationary cycle begins, stopping it can be quite the challenge.
The problem is that when prices decline due to lack of demand, they can go well below the cost to produce that product. Consequently, companies employ cost-cutting measures such as decreasing the production of the poor-performing products and laying off employees. Decreased number of paychecks can further decrease demand for the products. The examples are very numerous including Motorola recent layoff of 3000 employees and unveiling of new products, AmEx shedding 7000 employees to contain expenses, etc.
During deflation, one may be able to find Mercedes for half-price, expensive restaurants will close, and industries catering to those who spend frivolously will shut down. Home prices drop too. In fact, home prices can decrease so much that banks can call loans even if you are on time with your mortgage or ahead of your payment schedule. Deflationary markets are quite scary.
Our Risk Of Deflation
We have recently seen decreased prices for oil, grains, copper, and other commodities. Home prices have also tanked. Prices for furniture, appliances, tools, and hardware also appear to be declining. Currently, economists predict that our risk of deflation is about 10-30%, which is fortunately still pretty low. However, some of these same economists would have predicted it as less than 5%, suggesting that our risk of deflation appears to be increasing.
That still does not mean that economists are freely stating these concerns. In fact, in a recent speech San Francisco Federal Reserve Bank President Janet Yellen said that falling commodity prices, job losses and weak demand for products were likely to “push inflation down to, and possibly even below, rates … consistent with price stability.” To me, that sounds like a convert way to say that she is concerned about the risks of deflation. Notably, in the same speech she said that our economy does appear to be in recession even though she avoided using the term deflation. This is likely because deflationary periods are thought to be worse than recessions. Regardless of the terms used, these warnings have received the Feds attention. It appears that the recent handout of hundreds of billions of dollars to financial firms might have partially been motivated to decrease these risks.
Copyright 2008, Roshawn Watson, Pharm.D. All Rights Reserved.
Copyright 2012, Roshawn Watson, Pharm.D., Ph.D. All Rights Reserved.