Cost-Push Deflation?- Billmon in the

Cost-Push Deflation?- Billmon in the Daily Kos comments had some interesting comments on economics. He is afraid of deflation kicking in and doing a number on the economy.

But as I look around the world and the world's capital markets -- which is part of my current job -- I see some truly brutal deflationary pressures bearing down just about everywhere.

These aren't the kinds of economic problems supply-side remedies like lower marginal tax rates and deregulation were designed to fix (not that it will stop the supply siders from trying). And wars just aren't as stimulative as they used to be.

So that leaves Uncle Al Greenspan with the weight of the world resting squarely on his narrow bureaucratic shoulders. Shrub just better hope that Atlas doesn't shrug.

Deflation might not be that bad of a thing for the economy, depending on where the deflation is coming from. If cost-push inflation gave us the stagflation of the 70s, what would cost-push deflation look like?

If the deflation is due to a decrease in factor prices, especially imported factors such as oil, that would help shift the aggregate supply curve outward. Prices for factors go down, allowing the businesses to cut the cost of their products. The lower price for the products will spur increased demand for the products, thus increasing the real amount of good sold and increase employment. Yes, Bilmon, supply-siders can deal with deflation.

If you substitute productivity and technology gains for factor prices, that is what we’ve seen in the last decade. The Clintonistas will chalk up the 90s to a sound fiscal policy, but the lower interest rates of the era were offset by higher tax rates, creating a aggregate supply wash at best as a result of active government policies.

As long as the deflation is factor-price based, we have little to fear. If the deflation is due to a decrease in demand, then we have problems. If demand-pull inflation due to a goose in consumer demand creates inflationary growth, demand-pull deflation would cause a deflationary recession.

I don’t see that happening, but we could see that happen if we get a lack of new electronic toys for people to buy. Computers are in the process of becoming a mature industry, as is the VCR. However, we may start to hit a lull in electronics development, where we might have a few years without too many new gizmos to buy. That lack of new tech in the stores might put a crimp in new purchases.

Deflation has its other side-effects. Since interest rates=real interest rates + expected inflation + risk premia, you could see near-zero interest rates if that expected inflation factor become negative. That makes the interest-rate cut game of the Fed a non-issue; we can see a foretaste of that in Japan, where their equivalent of the Fed Funds rates hovers just a few basis points above zero. If we get the significant deflation that Bilmon is sensing, the Open Market committee can take a few months off, unless they change their focus to managing the amount of the money supply as opposed to the interest rate. Then, they could quietly manage the money supply without a interest rate focus but a true money supply focus, growing the money supply at the rate real GDP changes.

However, Japan's deflation seems to be demand based rather than supply based. Having the Fed on autopilot for a few months wouldn't be the worse thing in the world