Going Down

Here's what's happening: After an historic run-up in the middle part of this decade, consumer prices have fallen rapidly over the last two months--0.7 percent in December and 1.7 percent in November, which was the most severe price drop in 60 years. Everything from a gallon of gas to airlines tickets and clothing is much cheaper today than it was even just a few months ago. And the signs of deflation are not just in store windows. Inflation-indexed U.S. Treasury bonds, called TIPS, are signaling significant future deflation. The same is true for Japanese bonds that are indexed to inflation.

And just as prices spiking too quickly can create problems--as we saw with the bubble in the housing market--rapidly falling prices can create significant problems, too. They suggest to consumers that it's all right to hold off purchases and wait for a better deal later. Indeed, despite the historic price declines recently, that's precisely what American consumers are doing: hoarding their money and increasing their savings to ride out the economic turmoil brought on by the financial crisis.

This type of behavior poses a dangerous and long-term risk to stability. During a deflation, homeowners, businesses, and other debtors suffer extreme economic pain as the value of their assets fall while they are, by the terms of their mortgage contract, obligated to make payments based on previously elevated values.

Going Down