Pimco, the world’s biggest bond fund management company with over $1 trillion in assets under management said today that the U.S. is facing a growing risk of deflation. PC prices are “falling off a cliff” as consumer demand falls.
Deflation is the opposite of inflation because the general level of prices falls rather than rises as it does in an inflation. Falling prices mean rising value of the dollar as one’s income can purchase more goods and services with the same dollar amount.
But deflation paradoxically has the effect of reducing overall demand as consumers hold on to their money (which increases the overall level of consumer saving) in hopes of seeing prices fall even more. This is rational on the part of the consumer because money is more valuable than the potential goods and services that could be purchased with it. This decline in demand leads, in turn, to a fall in production, further aggravating unemployment and feeding the decline in demand. With demand falling of a cliff, business profits fall, too, forcing some companies into bankruptcy and adding to unemployment.
The solution is to reduce the value of money, usually by increasing its supply, something that the Fed can do. Indeed, news of the Fed buying Treasuries is part of such a move. But Bernanke has to watch out for the dreaded liquidity trap, a situation when increasing the money supply has no effect on the deflationary trend.
Deflation has the effect of increasing the cost of borrowing. Suppose, for example, that you have a 0% interest loan at the beginning of the year. If deflation is 3% a year, the cost of your loan at the end of that year is no longer 0% but 3% in phantom interest. And so deflation amplifies the chilling effect of debt on consumer spending because it raises the interest rate on that debt, often leading to a situation where the consumer is paying more in terms of purchasing power on the loan than he received through the loan’s proceeds. The individuals who benefit the most during a deflation are fixed income earners as well as creditors.