Oil Prices 2015: Why Economists Fear 'Nightmare' Deflation

When the U.S. Federal Reserve holds its next policy meeting at the end of the month, experts say the central bank should consider the consequences of deflation when making policy decisions.

Minneapolis Fed President Narayana Kocherlakota and other economists wrote in a recent paper that there’s an increasing possibility that deflation could creep into the U.S. economy. As oil prices tumble to lows not seen since the Great Recession, Kocherlakota and the paper’s other authors aren’t alone in the view that global markets are on the cusp of a fearsome disorder: Falling prices on a wide array of goods and services, a syndrome known as deflation.

Investors are worried about deflation, too, as evidenced in this week's volatile financial markets, as the Dow Jones Industrial Average tumbled as much as 239 points Tuesday after dropping 350 points in afternoon trading Monday.

For most consumers, it doesn’t make intuitive sense that economists should fret sliding prices, but deflation can lead to a stagnating economy. The simple explanation: In a deflationary environment, consumers resist making large purchases of just about everything in anticipation that prices will continue dropping and lead to better deals are ahead. The result is a broad slowdown of economic activity. Further, deflation makes it more difficult to pay off debt, something American consumers and many U.S. employers have a great deal of.

“Deflation is a nightmare and it’s difficult to cure,” Peter Cardillo, chief market economist at Rockwell Global Capital, says.

Deflation, not to be confused with disinflation, or a slowing rate of inflation, is dangerous because it reduces the supply of money and credit coursing through the economy, and it can create less demand for big-ticket items from cars to washing machines. At its worst, dwindling demand can lead to global depression.

It’s widely held that deflation contributed to the Great Depression’s massive rise of unemployment. Japan suffered from deflation during the mid-1990s, but the country still hasn’t been able to fully recover despite its ongoing massive monetary stimulus programs. Now, as Europe teeters on the brink of a triple-dip recession, the fear is that declining oil prices could lead to deflation and spread throughout the global economy.

Periods of deflation lead to higher unemployment. “As the old saying goes, if a loaf of bread goes from a dollar to a nickel, on the surface that’s good news,” Cardillo said. “But if you don’t have [a job to earn] that nickel and purchase that loaf of bread, that’s a problem.”

Signs of deflation are emerging more and more quickly. The European Union said Wednesday that consumer prices fell last month for the first time in more than five years. On Tuesday, U.S. crude oil dropped to $47.93 a barrel, its lowest level since April 2009. So far, the oil price slide has been good for oil-consuming countries such as the U.S. As prices drop for commodities, gasoline prices and other prices fall, putting money back into consumers’ pockets.

“The global economy is really walking a fine line between outright disinflation and deflation,” Karl Snyder, chief market strategist at Garden State Securities, says. “It’s not that low oil prices are bad, because low gasoline prices are good for the consumer,” Snyder says. “It’s what oil prices may be signally, and what they might be potentially signaling is lack of demand, leading to deflation.”

There is some evidence that the global economy is heading toward deflation, says Snyder. Some investors and institutions have already begun hedging against it by purchasing vast amounts of U.S. treasury bonds. The yield on 10-Year U.S. Treasury note dropped below 2 percent Tuesday, hitting the lowest level since May 2013, signaling deflation fears are heightening investor demand for safe haven assets. Meanwhile, the price of gold -- another asset often seen as a safe haven -- jumped to a three-week high Tuesday. In a deflationary environment, cash also becomes more attractive. It's not accident that the U.S. dollar surged to an 11-year high last week against other major currencies.