Friday, February 19, 2010

Deflation Dragon

Does the U.S. need a knight in shining armor? Some economists are convinced the ugly dragon of deflation is just beyond the horizon, poised to swoop in an begin devouring whole industries with large bites out of prices, production and employment. Anyone who has been through a deflationary period knows it is not a fun time.

The real question is not the absurd notion of heroes with battle ready swords. It is one of economic reality. Is not a reduction in prices, particularly contract rent (i.e. what we pay for factory capacity or office space), a necessary part of de-leveraging the U.S. economy?

Deflation is defined as a decrease in the Consumer Price Index. Unfortunately, the index as it is presently calculated does not include house prices (which have declined dramatically over the last two years). It includes instead a figure for “rent.” The index than is actually a very poor barometer of deflation since rent increases when house prices are high and individuals shift to rental properties. Conversely when house prices fall - as they have recently - rents decline as demand shifts back to ownership.

The CPI aside, the Federal Reserve appears to be reading its own barometer. Yesterday the Fed increased the Federal Funds rate by one-quarter point to a whopping 0.75%.

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