What Could Cause Deflation?

The Federal Reserve is not pleased that inflation is so low. There is some fear that the very low inflation could lead to deflation. Yet, what could actually cause prices to begin to decline? Consumer psychology would be mostly to blame.

The latest Thomson Reuters/University of Michigan Surveys of Consumers Purchase Motivations Report explains why central bankers might be worried. It says that consumers' current spending plans are more likely to encourage deflation now than any other time since the Great Depression. That's because most consumers either aren't spending or are looking for deep discounts before they do.

In particular, the survey found that 31% of respondents are not buying household durable goods because they are concerned about current and future job and income prospects. With unemployment remaining near double-digits and the recovery proceeding very slowly, it's easy to understand why. Another large portion of the population -- 43% -- is only making durable good purchases when deep discounts are available. Together, these two groups account for nearly three-quarters of consumers.

Both those attitudes would encourage deflation. You've got the vast majority of Americans either not spending money or only doing so when they get rock-bottom prices. That will create an environment where retailers feel pressured to lower prices. As prices fall, widespread deflation could result.

Moreover, expectations play a part here. If inflation is widely anticipated by consumers, then they might buy more with less concern for bargains. After all, if you expect prices to rise, then it's better to buy now when they are relatively low. But Americans don't have much fear that retailers will begin raising prices anytime soon. Demand is so anemic already that they can't afford to charge more.

Still, the report suggests that widespread deflation isn't likely. The economy is slowly improving, so in coming months Americans will become more and more comfortable spending more money. Moreover, the Federal Reserve is likely to take measures to loosen monetary policy, which should combat deflationary pressures. If firms have cheaper borrowing costs, then even lackluster sales will more easily cover costs, without the need to cut prices deeply to conjure up demand for more sales. So even though consumer psychology right now might be very conducive to deflation, the U.S. may manage to avoid it if the recovery continues and the Fed's intervention works.