Snapshot for February 12, 2003.

U.S. may be on verge of deflationary spiral

In his February 11, 2003 testimony to the Senate Committee on Banking, Housing, and Urban Affairs, Federal Reserve Chairman Alan Greenspan expressed optimism about an economic recovery, saying:

…there have been signs recently that some of the forces that have been restraining the economy over the past year are starting to diminish, and that activity is beginning to firm.

Mr. Greenspan may be overly optimistic. In particular, the U.S. economy may be on the verge of sustained deflation (negative rates of inflation). Deflation squeezes profit margins for businesses with fixed costs (like debt service) and increases real interest rates, slowing business investment. In short, it makes it much harder to revive a sluggish economy. Beginning in the second quarter of 2001—the start of the last recession—rising unemployment has been accompanied by a sharp decline in producer price inflation.* Since 1974 (the first year in which data on this measure of inflation is available), there have been five months characterized by deflation. Four of these occurred in the second half of 2002.

Deflation has contributed heavily to the decade-long slump in the Japanese economy. Avoiding this scenario should be a prime concern of U.S. policymakers. An intelligent stimulus package—one that provides immediate, temporary relief to those states and individuals who will spend the money quickly—could help avert a deflationary spiral by lowering unemployment and increasing aggregate demand. For more on economic stimulus, see EPI’s stimulus publications page.

*Inflation is defined as the 12-month change in the producer price index (PPI) for finished goods less food and energy. Other measures, such as the consumer price index (CPI), display a similar trend. The PPI and the unemployment rate are obtained from the Bureau of Labor Statistics.

This week’s Snapshot by EPI economist Josh Bivens.

Check out the archive for past Economic Snapshots.