By John W. Schoen Senior producer
msnbc.com
updated 11/21/2008 12:10:35 PM ET 2008-11-21T17:10:35

After years of punishing increases in the cost of energy, consumers are rejoicing these days at the sharp drop in prices at the pump. Not only that, but prices are dropping for clothing, transportation and housing, according to the government's latest report on consumer prices . With money tight, the price declines are a welcome relief.

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But be careful what you wish for. If price declines continue and become more widespread, there’s a risk the downward trend could feed on itself in a spiral that can take on a ruinous momentum. It’s called deflation. And some economists are warning the threat is increasing.

“A benign decline in prices amidst a sluggish but recovering economy would be unwelcome but tolerable,” Merrill Lynch economist David Rosenberg wrote in a note to clients this week. “But the price slashing now under way as the consumer beats a hasty retreat could allow that corrosive deflationary spiral to take hold — something the Fed wants to avoid at all costs.”

Although the risk is still considered relatively small, concern about deflation is one reason stocks have been hammered this week, sending the broad Standard & Poor's 500 to its lowest close since 1997 Thursday. The rapid slowdown in the economy, coupled with the collapse of housing and financial markets, has increased the threat of a broad, sustained drop in prices.

While deflation might sound welcome, in fact it can be devastating to borrowers, banks and businesses. The Great Depression in the 1930s was accompanied by deflation of 10 percent per year, reflecting the widespread lack of demand.  Falling prices in the 1890s made it impossible for farmers to keep up with mortgage payments, as Fed Chairman Ben Bernanke noted in a 2002 speech on the topic.

As prices fall, consumers and businesses become less willing to spend and invest, worsening the economic downturn, as happened in Japan's "lost decade" of the 1990s.

A sustained drop in prices hurts in two ways. First, because consumers and businesses anticipate prices will continue to fall, they would likely cut back further on spending and investment. Why shell out $1,200 for that flat-panel TV today when you can get it for $800 six months from now?

As spending dries up, the economy starts to shrink; about two-thirds of the U.S. gross domestic product is based on consumer spending. As GDP shrinks, so do the companies providing those goods and services for consumers. As companies shrink or go out of business, unemployment rises. Out-of-work consumers have less money to spend, which cuts deeper into the economy. Once the cycle takes hold, it's very difficult to stop.

Deflation brings another, potentially bigger problem for an economy swollen with too much debt. Inflation is good news for anyone who owes money because, as prices rise, spending power is eroded and the real value of money declines. When inflation is rampant, you get to pay back the $1,000 you borrowed last year with dollars that are worth a little less each year.

That debtor advantage is turned upside down if deflation takes hold. As prices fall, the spending power of your money goes up. But so does the real value of your debt — because you have to pay it back with money that has increased in real value.

Several forces are combining to create downward price pressure. The sharp slowdown in global growth has cut demand and created an oversupply of commodities — from oil to scrap paper — sending prices of those commodities crashing. That can translate into falling prices of finished goods.

The recent sharp pullback in consumer spending puts added pressure on producers to cut prices as they try to spur sales. Consumers will likely continue to hold back on spending as long as unemployment rises and household wealth shrinks due to dropping asset values.

If deflation were to take hold, the impact could be even worse than the 1970s inflation outbreak that devastated the economy and destroyed wealth for nearly a decade. Federal Reserve policymakers could find themselves in a tight spot. Just as higher interest rates are the antidote for inflation, lower rates are the government’s main weapon against deflation.

But having already slashed the benchmark overnight lending rate to just 1 percent from 4.25 at the beginning of 2008, the Fed is running out of room to cut rates further. In fact, as worried investors have moved piles of cash into short-term Treasuries in the past few weeks, the Fed has missed its target, and the market has pushed short-term rates to just 0.25 percent.

Fed officials are keenly aware of the deflation risk. On Wednesday, Fed Vice Chairman Donald Kohn said the “most likely outcome” was that the economy will not see an outbreak of deflation. But he said Fed policy should be focused on making sure that doesn’t happen.

"Some people have argued that we should save our ammunition, that interest rate cuts aren't effective," he said. "I think that were we to see this possibility, that we should be very aggressive with our monetary policy, as aggressive as we can be."

If deflation were to take hold, the Fed wouldn’t have to do all the heavy lifting; government policies on taxing and spending could also provide a major deterrent.

The recent, huge injection of hundreds of billions of dollars into the banking system should help offset deflationary pressures. Tax cuts could help, along with further increases in government spending on rebuilding roads and bridges. As the government pumps money into the economy and financial system that generally boosts inflation and should limit the odds that deflation could take hold.

Deflation worries surfaced earlier this decade as the economy was emerging from recession after the bursting of the Internet bubble and 9/11 terrorist attacks. Deflation concerns played a role in the Fed’s decision to keep interest rates low after the economy began recovering. Though the recession officially ended in November 2001, the Fed kept cutting rates and did not begin raising them again until June 2003.

The following month, current Fed Chairman Ben Bernanke, then a Fed governor, told a group of economists meeting that deflation was not a serious threat because “financial conditions in the United States today are sound.”

“Deflation can be particularly harmful when the financial system is already fragile, with household and corporate balance sheets in poor condition and with banks undercapitalized and heavily burdened with nonperforming loans,” he said in that speech.

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