Sputtering economy raises fears of deflation

WASHINGTON – The White House prediction Friday that the deficit would hit a record $1.47 trillion this year poured new fuel on the fiery argument over whether the government should begin cutting back to avoid future inflation or instead keep stimulating the economy to help the still-sputtering recovery.

But increasingly, economists and other analysts are expressing concern that the United States could be edging closer to a different problem – the kind of deflationary trap that cost Japan more than a decade of growth and economic progress.

And as Tokyo’s experience suggests, deflation can be at least as tough a problem as the soaring prices of inflation or the financial pain of a traditional recession.

When deflation begins, prices fall. At first that seems like a good thing.

But soon, lower prices cut into business profits, and managers begin to trim payrolls. That in turn undermines consumers’ buying power, leading to more pressure on profits, jobs and wages – as well as cutbacks in expansion and in the purchase of new plants and equipment.

Also, consumers who are financially able to buy often wait for still lower prices, adding to the deflationary trend.

All these factors feed on one another, setting off a downward spiral.

For now, the dominant theme of the nation’s economic policy debate remains centered on the comparative dangers of deficits and inflation. However, economists across the political spectrum – here and abroad – are talking more often about the potential for deflation.

So how likely is the problem?

The latest U.S. data are sobering: Consumer prices overall have declined in each of the last three months, putting the inflation index in June just 1.1 percent above a year earlier. The core inflation rate – a better gauge of where prices are going because it excludes volatile energy and food items – has dropped to a 44-year low of 0.9 percent.

That’s well below the 1.5 percent-to-2 percent year-over-year inflation that the Federal Reserve likes to see, and some Fed policymakers have raised concerns about the rising risk of a broad decline in prices.

Private economists and financial experts have expressed much greater concern.

“I think we have to take it seriously,” said John Mauldin, president of Millennium Wave Advisors in Dallas, who puts the probability of deflation at more than 50 percent. Among the reasons he cites: a lot of unused labor and production capacity, increased savings and the low speed at which money is changing hands.

“It’s a good bet that by some measures we’ll be seeing deflation by some time next year,” Paul Krugman, the Nobel laureate economics professor, said this month in his New York Times column. He went on to scold the Fed for standing idle while the nation is “visibly sliding toward deflation.”

But the Fed’s chief, Ben Bernanke, appears to think deflation fears are overblown. During his semiannual testimony to Congress last week, he told senators that he didn’t view deflation as a near-term risk.

In the Fed’s latest forecast, core inflation is projected to stay at the current pace this year, then gradually rise toward 1.5 percent in 2012.

Should deflation occur, the central bank has the tools to reverse it, he said. But many question whether the Fed can do much more, given that it already has pushed interest rates to historic lows and pumped more than $1 trillion into the financial system.

Also, Bernanke said, America’s economy is more vibrant and productive than Japan’s was, and its labor force isn’t declining, whereas Japan’s has been for much of the last decade. Japan also was much slower in addressing problems with its banking sector than the U.S., he said.