Is Deflation Possible?

There is a lot of confusion with the term deflation.  The term really should be defined as a contraction of the money supply.  Most people use it in reference to prices.  Either way, is it possible in today's environment?  The short answer is yes, but it is also unlikely.

It is hard to talk about deflation when it comes to prices.  The reason is because it is hard to get an accurate reading of the overall price level.  In the last few years, housing prices have dropped dramatically while food prices have continued to increase, even if slowly.  It is also hard because of other factors.  Healthcare and education costs continue to skyrocket, but part of that can be blamed on government laws and regulations, not just fiat money.  Meanwhile, flat panel televisions get better and cheaper.  Increased productivity and increased technology can both lead to decreasing prices, even in the face of monetary inflation.  This is a good thing.

With that said, are we likely to see deflation any time soon, whether we use the consumer price index (CPI) or a money supply statistic?  I think it is highly unlikely.  The closest thing we might see is that as the money supply continues to increase, banks will just increase their excess reserves.  This will put a lid on prices from rising dramatically.  We might be lucky to see a flat or slightly increasing CPI, similar to what we see now.

With all of the stimulus money, bailouts, and "quantitative easing", there are severe distortions in the market.  The distortions that were trying to correct in 2008 were not allowed to correct.  In the past 2 years, the government and the Fed have increased these distortions on a monumental scale.  We need to go through a severe recession to shake out all of the misallocations.  The government and Fed are not allowing this to happen.  The longer they continue to avoid it, the worse it will be.

I would not bet on deflation.  This would be betting against the Fed's ability to create money out of thin air.  This is highly unlikely in the near future.  When we start to see high price inflation and the Fed pulls back to prevent a runaway inflation, then we might see something like deflation.  At the very least, we might see price deflation as the demand for money increases.  This is what we should hope for.  We should hope for it sooner rather than later.  Unfortunately, I think we are years away before the really big shakeout begins.