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Dipping and Deflating

Thursday, July 29, 2010

A double-dip recession now appears all too probable, likely tipping the U.S. economy into deflation.

As the Federal Reserve puts a brave face on the recent spate of weak U.S. economic data, one has to hope that it is not underestimating the very real risk of a double-dip U.S. recession by early next year. A double-dip recession now appears all too probable and such an occurrence would more than likely tip the U.S. economy into deflation. A Fed once again behind the policy curve would only exacerbate the long-run damage that such deflation can wreak.

The reason the Fed should guard against a double-dip recession is not simply that recent U.S. economic data points to a marked slowing in the economy. It is rather that the U.S. economic recovery has been very weak to date. This has been the case despite the extraordinary depth of the recession that preceded it and despite the remarkable amount of fiscal support provided to the economy.

Following an unprecedented four quarters of negative economic growth in 2008-2009, the U.S. economy has managed to grow at a little more than 3 percent over the past four quarters. And it has done so despite the fiscal stimulus alone contributing as much as 2.5 percentage points to U.S. economic growth in that period, while the inventory cycle has made a further significant contribution to growth.

In 2008-2009, the U.S. economy has managed to grow at a little more than 3 percent over the past four quarters.

The anemic economic recovery to date despite massive artificial support raises a rather basic question. Will the U.S. economy experience a double-dip recession towards the end of 2010 once the beneficial impact of the fiscal stimulus on gross domestic product growth has totally faded and once the present strong support to the economy from the inventory cycle has run its course?

Sadly, the U.S. economic recovery presently faces a number of strong headwinds that make a relapse into recession all too likely. The most serious of these headwinds is the appalling state of the U.S. labor market, which is now weighing heavily on income growth. If one includes discouraged workers and involuntary part-time workers in the unemployment total, as does the Labor Department in its U-6 unemployment measure, the overall U.S. unemployment rate has risen from 9 percent prior to the recession to a staggering 17 percent of the labor force at present. In response to large labor market gaps, U.S. hourly wage compensation is now rising by barely 1 percent a year, or by its lowest rate in the post-war period.

At the same time that weak income growth clouds the prospect for consumer spending, the ongoing U.S. foreclosure crisis threatens further damage to the housing market. Further weighing on the U.S. economy are the prospective cuts in state and local government spending, the ongoing bust in the commercial real estate market that will have a particularly adverse impact on the country’s regional banks, and the souring of U.S. export prospects as a consequence of the ongoing Eurozone sovereign debt crisis.

The U.S. economic recovery presently faces a number of strong headwinds that make a relapse into recession all too likely.

A marked slowing of the U.S. economy at this juncture must raise deflationary fears, since it would exacerbate the extraordinarily large labor and product market gaps that presently characterize the economy. The slowing would also be occurring at a time when U.S. inflation is already at a very low level. Indeed, over the past six months, core consumer prices have been increasing at an annualized rate of barely 0.6 percent, or at their slowest rate in the past 50 years.

If Japan’s experience with deflation offers any guide, one must expect that allowing deflation to take hold would highly complicate the prospects for a renewed meaningful economic recovery. It would do so by increasing the real cost of borrowing, inducing consumers to defer spending, and increasing the real-debt burden of households and corporations.

In the recent past, the Federal Reserve has not distinguished itself either by anticipating economic downturns or by taking timely preemptive measures to cushion the damaging fallout from such downturns. It is to be hoped this time around the Federal Reserve will have learnt from its past mistakes and will not find itself again behind the policy curve as the United States relapses into recession.

Instead, one hopes that the Fed will stand ready to credibly commit itself to keeping its policy interest rates at the present level until inflation increases back towards the Fed’s implicit 2 percent target. One must also hope that the Federal Reserve will stand ready to engage in aggressive quantitative easing as needed to prevent deflation from taking hold. The alternative would seem to be a long and painful period of deflation.

Desmond Lachman is a resident fellow at the American Enterprise Institute.

FURTHER READING: Lachman regularly monitors the Federal Reserve, reporting that the “Greek Tragedy Could Have Multiple Acts,” “Maybe Milton Was Right About the Euro,” and “Expect a Steady Fed.” He has also discussed “The European Threat to the South African Economy,” “The Risk of ‘Second Leg’” in the United States, and the “Storm Clouds Ahead for President Obama.”

Image by Darren Wamboldt/Bergman Group.

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