Explainer: Why is deflation so harmful? - CBS News
Positive correlation between inflation and unemployment creates a unique set of challenges for fiscal policymakers. with higher inflation, while high unemployment corresponds with lower inflation and even deflation. From a. The relationship between inflation rates and unemployment rates is inverse. .. Disinflation is not the same as deflation, when inflation drops below zero. How can inflation affect unemployment, and vice versa? Here, we examine the relationship between wage inflation, consumer prices, and.
These critics claimed that the static relationship between the unemployment rate and inflation could only persist if individuals never adjusted their expectations around inflation, which would be at odds with the fundamental economic principle that individuals act rationally. But, if individuals adjusted their expectations around inflation, any effort to maintain an unemployment rate below the natural rate of unemployment would result in continually rising inflation, rather than a one-time increase in the inflation rate.
This rebuttal to the original Phillips curve model is now commonly known as the natural rate model. The natural rate of unemployment is often referred to as the non-accelerating inflation rate of unemployment NAIRU.
When the unemployment rate falls below the natural rate of unemployment, referred to as a negative unemployment gap, the inflation rate is expected to accelerate. When the unemployment rate exceeds the natural rate of unemployment, referred to as a positive unemployment gap, inflation is expected to decelerate. The natural rate model gained support as s' events showed that the stable tradeoff between unemployment and inflation as suggested by the Phillips curve appeared to break down.
Unemploymentby [author name scrubbed]. The CBO estimates the NAIRU based on the characteristics of jobs and workers in the economy, and the efficiency of the labor market's matching process.
The economy is most stable when actual output equals potential output; the economy is said to be in equilibrium because the demand for goods and services is matched by the economy's ability to supply those goods and services. In other words, certain characteristics and features of the economy capital, labor, and technology determine how much the economy can sustainably produce at a given time, but demand for goods and services is what actually determines how much is produced in the economy.
As actual output diverges from potential output, inflation will tend to become less stable. All else equal, when actual output exceeds the economy's potential output, a positive output gap is created, and inflation will tend to accelerate.
When actual output is below potential output, a negative output gap is generated, and inflation will tend to decelerate. Within the natural rate model, the natural rate of unemployment is the level of unemployment consistent with actual output equaling potential output, and therefore stable inflation.
How the Output Gap Impacts the Rate of Inflation During an economic expansion, total demand for goods and services within the economy can grow to exceed the economy's potential output, and a positive output gap is created. As demand grows, firms rush to increase their output to meet this new demand. In the short term though, firms have limited options to increase their output. It often takes too long to build a new factory, or order and install additional machinery, so instead firms hire additional employees.
As the number of available workers decreases, workers can bargain for higher wages, and firms are willing to pay higher wages to capitalize on the increased demand for their goods and services. However, as wages increase, upward pressure is placed on the price of all goods and services because labor costs make up a large portion of the total cost of goods and services. Over time, the average price of goods and services rises to reflect the increased cost of wages.
The opposite tends to occur when actual output within the economy is lower than the economy's potential output, and a negative output gap is created. During an economic downturn, total demand within the economy shrinks. In response to decreased demand, firms reduce hiring, or lay off employees, and the unemployment rate rises.
As the unemployment rate rises, workers have less bargaining power when seeking higher wages because they become easier to replace. Firms can hold off on increasing prices as the cost of one of their major inputs—wages—becomes less expensive. This results in a decrease in the rate of inflation.
As discussed earlier, the natural rate of unemployment is the rate that is consistent with sustainable economic growth, or when actual output is equal to potential output. It is therefore expected that changes within the economy can change the natural unemployment rate.
Labor market composition, 2. Labor market institutions and public policy, 3. Productivity growth, and 4. Long-term—that is, longer than 26 weeks—unemployment rates. Individual worker's characteristics affect the likelihood that a worker will become unemployed and the speed or ease at which he or she can find work. For example, younger workers tend to have less experience and therefore have higher levels of unemployment on average. Consequently, if young workers form a significant portion of the labor force, the natural rate of unemployment will be higher.
Alternatively, individuals with higher levels of educational attainment generally find it easier to find work; therefore, as the average level of educational attainment of workers rises, the natural rate of unemployment will tend to decrease. For example, apprenticeship programs provide individuals additional work experience and help them find work faster, which can decrease the natural rate of unemployment.
Alternatively, ample unemployment insurance benefits may increase the natural rate of unemployment, as unemployed individuals will spend longer periods looking for work. According to economic theory, employee compensation can grow at the same speed as productivity without increasing inflation.
Individuals become accustomed to compensation growth at this speed and come to expect similar increases in their compensation year over year based on the previous growth in productivity. A decrease in the rate of productivity growth would eventually result in a decrease in the growth of compensation; however, workers are likely to resist this decrease in the pace of wage growth and bargain for compensation growth above the growth rate of productivity.
This above average compensation growth will erode firms' profits and they will begin to lay off employees to cut down on costs, leading to a higher natural rate of unemployment.
The opposite occurs with an increase in productivity growth, businesses are able to increase their profits and hire additional workers simultaneously, resulting in a lower natural rate of unemployment.
Individuals who are unemployed for longer periods of time tend to forget certain skills and become less productive, and are therefore less attractive to employers. In addition, some employers may interpret long breaks from employment as a signal of low labor market commitment or worker quality, further reducing job offers to this group.
As the proportion of long-term unemployed individuals increases, the natural rate of unemployment will also increase. Understanding the relationship between the current unemployment rate and the natural rate is important when designing economic policy, and the fact that the natural rate can shift over time further complicates the design of economic policy.
As shown in Figure 1the estimated natural rate of unemployment has been relatively stable over time, shifting from a high of 6. As shown in Figure 1the estimated natural rate slowly increased in the late s, s and the early s. Several economists have suggested that much of this increase in the natural rate, from about 5.
A portion of this decrease in the s is likely due to baby boomers becoming more experienced and productive workers. The sharp decrease in the s has been largely explained by an increase in the rate of productivity growth in the economy.
Productivity growth, total output per hour of labor, was about 1. Data are not seasonally adjusted. Beginning inthe natural rate began to increase sharply, as shown in Figure 1. The rapid increase in the natural rate after can largely be explained by changes in the makeup of the labor force and changes in government policy.
Individuals who are unemployed for longer durations tend to have more difficulty finding new jobs, and after the recession, the long-term unemployed made up a significant portion of the labor force, which increased the natural rate of unemployment.
In addition, some research has suggested the extension of unemployment benefits may also increase the natural rate of unemployment. Two prominent factors that also impact the rate of inflation are 1 expected inflation and 2 supply shocks.Inflation and Unemployment (Revision Webinar)
Firms will also incorporate inflation expectations when setting prices to keep the real price of their goods constant. For businesses producing for global demand, having assets in countries with depreciating currencies and higher inflation will be advantageous. The income statement From an income statement perspective, accounting for inventory using the FIFO method will be most beneficial, reducing the tax liability that can come from inflationary gains.
Hedging future inventory price increases will become a common practice for a wide variety of different resources. Hedging will be done for both price as well as currency risk. The airline industry provides a prominent example, with some players having become adept at hedging their fuel risk.
With the dollar declining in an inflationary environment, every business that depends on commodities or imported resources will need to hedge their price and currency risk. Pricing becomes a significant challenge in an inflationary environment.
Increasing prices can always be challenging, but in an inflationary environment it will become a requirement for success. Changing product size and packaging as a way of drawing attention away from price changes will become a common practice. Firms may also consider lengthening contracts with vendors to create some degree of certainty. Of course, maintaining the ability to increase prices to customers on a more frequent basis is a critical component of a go-to-market strategy.
Managing wage and salary costs also will become a more complicated task. With the dollar declining in value, the benefits of outsourcing will be diminished. Labor unions and even nonunionized workers will seek out cost of living protections, which will institutionalize cost increases. At the end of the day, an inflationary environment requires a more nuanced understanding of the time value of money. Effective financial management becomes the key to operational success even at the expense of operational efficiency.
The case for deflation "Thus Inflation is unjust and Deflation is inexpedient. Of the two perhaps deflation is The lesson from Japan in the s was that credit destruction was the key driver in both reducing the supply of money while at the same time increasing its demand.
That same dynamic is now playing out in the U. A rising demand for money can be seen in the actions of banks, households and corporations. The rise in cash holdings can be attributed in large part to a strong rebound in corporate profitability coupled with high levels of uncertainty over the impact of recently passed health care and financial services regulation.
Potential changes in the rate of future taxation of corporate income have also added to the uncertainty. For households, high levels of unemployment and fear of future job loss have added to their uncertainty. Household savings began to rise in mid as the recession deepened.
This is the sharpest increase in savings in the post-World War II era. By increasing their demand for money, consumers have reduced their pace of spending, putting downward pressure on prices. At over 14 percent of disposable income, the household savings rate in the eurozone is among the highest in industrialized nations. Maybe owing to its post-war experience and fear of hyperinflation, there is a clear preference for savings over debt on the continent.
However, despite this fundamental commonality, there has been a divergence within the eurozone in the choices of private households in recent years: Federal Reserve Board Figure 3: Nonfinancial, nonfarm corporations Liquid assets, in billions of dollars Source: Bureau of Economic Analysis Figure 4: Household savings Billions of dollars, month moving average Source: Private sector deleveraging has been widespread over the past two years.
From mortgage debt to consumer debt, from commercial and industrial lending to commercial paper, private sector indebtedness has seen the largest decline in the post-World War II era. The elimination of debt represents a decline in demand and a contraction the supply of money.
Coupled with the increase in cash holdings, this dramatic shift in private sector balance sheets is dramatically contributing to deflation by increasing the demand for, while reducing the supply of money. Structural changes in the economy are giving deflation an additional boost. The explosive growth in labor productivity coupled with the still high levels of unemployment point to falling labor costs. As prices tend to follow labor costs, this combination will add to deflationary pressures in the economy as businesses take these costs out.
Business sector productivity growth peaked at 6. While high productivity growth is keeping a lid on the demand for labor, high unemployment is giving a boost to supply.
For much ofthe unemployment rate averaged above 9.
Broader measures of unemployment that include discouraged workers and those working part time for economic reasons range as high as 17 percent. High levels of labor market slack will keep a lid on wage gains, reducing consumer purchasing power in the process and putting downward pressure on prices.
Federal Reserve Board Figure 6: Private sector debt In trillions of dollars Source: Federal Reserve Board Figure 7: Even with the recent rebound, capacity utilization remains at levels below those reached in most of the post-World II recessions.
Federal Reserve Board Output as a percentage of capacity Planning for deflation In many ways deflation is the obverse of inflation, driven by the fact that cash will be worth more in the future than it is today. Actors then have the desire to hold on to cash and defer purchases since they can buy goods more cheaply in the future. During deflation, then, holding financial assets is preferable to holding real assets.
Explainer: Why is deflation so harmful?
It is better to be a creditor than a debtor, if you assume that your debtor will remain solvent and that any collateral posted will hold enough value to cover the face amount of the debt. Cash as an appreciating asset is king. There are, however, two key asymmetries with respect to inflation that pose fundamental challenges to managing during deflation. The first is that nominal interest rates cannot go below zero no one would ever pay a bank to hold money for them!
The second key asymmetry is wages. During deflation, even wages that are flat in nominal terms will become higher over time in real terms. Going beyond that, to reduce nominal wages, is exceedingly difficult: This ratchet effect poses perhaps the most difficult management challenge during deflation.
Ultimately, the responses to sticky wages are to not hire in the first place generally using temporary workers insteadreduce the work force through attrition or, more proactively, reduce wages. An especially pernicious consequence of deflation is that consumers and firms rationally defer spending because they expect nominal prices of goods and services to decrease. Because spending is deferred, many individuals and firms will suffer some degree of financial distress, so the risk of defaults increases.
As this spiral plays out, creditors, who should benefit from falling prices, may find themselves holding a defaulted asset. Even if it has a higher real face value, holding it through bankruptcy court is a pyrrhic victory. So what are the financial levers that firms expecting deflation can pull?
Unemployment and Inflation
Organizations should increase their working capital and reduce their holdings of real assets, including inventory which will benefit from LIFO accounting. They should reduce long-term borrowing and in general reduce the duration of their liabilities. Moving away from fixed costs to more variable arrangements would be prudent.
Finally, diversifying the revenue and expense base by moving internationally can provide something of a hedge against domestic deflation. Increasing exposure to alternative currencies with higher real interest rates, particularly if there is a natural cash flow match, will be helpful in maintaining a decent rate of return on working capital.
From an operational perspective, deflation should prompt firms to increase their focus on operational efficiency, including improving their management systems.
For firms with a solid financial footing, it can be a good time to protect market leadership as weaker firms feel the strain and potentially exit. They may find that they can strengthen long-term customer relationships by providing vendor financing assuming, of course, that the borrower is creditworthy.
Working creatively with both vendors and customers to structure innovative payment terms that are mutually beneficial can again fortify relationships. As purchasers of goods or services, firms should shift to shorter-term contracts that can be renegotiated when prices are lower. Unlike wages, prices can be negotiated downward, particularly when there are natural resets that occur at contract expiration dates.
Deflation presents asymmetric challenges that few who play in the economic environment of the developed world have ever had to contend with. Notably, negative real interest rates and sticky wages are unique. This can be a time for strong firms to improve their competitive position, gain market share and expand their global footprint.
Creating options to manage uncertainty Whether the economy will experience inflation or deflation will remain an intense topic of debate. If a company is unsure whether inflation or deflation is next but wants to prepare nevertheless, there are certain common strategies that will stand it in good stead. While all of these ideas make sense in good times and bad, they become particularly relevant during times of uncertainty.
All involve increasing future degrees of freedom by creating more strategic options for the firm. The first requirement of operating in such an uncertain environment is to monitor changes in inflationary expectations. The Federal Reserve of Cleveland has a widely accepted methodology for tracking inflationary expectations. Such expectations tend to lead price movements and are a good leading indicator of future price movements.
Within an industry or business there may be other leading price indicators. Business leaders may incorporate these into an economic dashboard that provides a sense of which way prices might be breaking. The second strategy involves increasing diversification along a range of dimensions: This may also include being roughly neutral with respect to duration-matching assets and liabilities, while at the same time shortening that duration.