Three reasons why lower oil prices won't lead to a 'deflationary spiral'

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Economists and central bankers hate deflation because of "deflationary spirals."

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A "deflationary spiral" occurs when lower prices cause consumers to wait for even lower prices, creating excess production capacity, excess inventory, and ever-lower prices and so on. It is a circular pattern.

In a note to clients last week, Bank of America Merrill Lynch economist Ethan Harris took to task the idea that the deflation - or really, disinflation - that we're seeing due to the crash in oil prices will lead to a much-feared "deflationary spiral."

Harris outlines this basic sketch as what some members of the press, the analyst community, and even central bankers have said are the dangers of lower oil prices:

The typical spin is as follows. Lower oil prices may be good for consumers, but it creates a serious deflation risk. Falling prices could cause companies and consumers to postpone purchases, weakening the economy. This in turn means central banks will need to ease policy further.

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For Harris, deflation has three main negative effects, none of which are relevant to the drop in oil prices:

  • Deflation makes it harder for debtors to service their debt
  • Deflation delays spending
  • Deflation makes it hard for a central bank to lower interest rates and stimulate the economy

Harris answers each of these concerns as follows:

  • Lower oil prices are good for debtors. For households it increases income available for spending or for repaying debts. For governments of oil importers lower oil prices raise revenues - gas tax collections go up slightly as people buy a bit more gas and the stimulus to consumer spending raises sales and income taxes more than it lowers tax payments from oil producers and workers.
  • Lower gasoline prices do not delay spending, they encourage spending. Other than waiting a day or two for lower prices to reach the pump, lower oil prices stimulate demand for gasoline (slightly). More important, they free up spending on other items. I've never heard anyone say, "I'm going to delay buying that wide screen TV until gas prices drop further."
  • Lower gas prices do not make the central bank's job harder, they make it easier. Lower prices mean both less inflation and stronger growth. Moreover, lower oil prices do not raise the real interest rate that is relevant to borrowers. What impacts borrowing is the nominal rate relative to ability to repay the loan. Ultimately it is wage and salary income and prices of domestic products that determine the ability of households and businesses to repay loans. Hence, oil price deflation only raises real borrowing cost for oil producers.

And overall, Harris writes that this is what folks need to keep in mind when talking about "deflationary spirals" and the more sinister impacts deflation can have on economic growth:

Deflation is bad if it lowers the price of domestically produced goods, encouraging buyers to delay purchases and making it harder for companies to repay debt. Deflation is also bad if it means weak growth in both wages and incomes. By contrast, deflation from falling oil prices is good news for every country that is a net importer.

So don't worry.

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