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Falling Consumer Prices Good or Bad News for Consumers?

Economics / Inflation Nov 20, 2008 - 02:07 AM GMT

By: Paul_L_Kasriel

Economics Best Financial Markets Analysis ArticleThursday the BLS reported that the Consumer Price Index (CPI) fell by 1.0% both seasonally adjusted as well as unadjusted. On an unadjusted basis, this was the largest monthly decline in the CPI since January 1938 (see Chart 1). Some journalists and some economists are exclaiming that these falling consumer prices are "good" for consumers. Are they?


Chart 1

Prices are determined by the interactions of supply and demand. Prices can fall because supply is expanding; prices can fall because demand is contracting. One way in which supply can increase is through increases in productivity or advances in technology. In both cases, the cost of production goes down. Competition among producers results in lower prices for consumers. If prices are falling because of expanding supply, then we would expect to observe increased quantities of consumer goods and services being sold. One way in which demand can contract is through falling household incomes. With falling incomes, households might be expected to cut back on their consumer spending, all else the same. If prices are falling because of contracting demand, then we would expect to observe decreased quantities of consumer goods and services sold.

With the decline in consumer prices of late, what have we observed with respect to household income? A proxy for household income - private nonfarm payrolls multiplied by average weekly earnings - has fallen for two consecutive months (see Chart 2). Thus, a prima facie case can be made that the demand for consumer goods and services might be contracting.

Chart 2

With both the decline in consumer prices and the decline in the proxy for household income of late, what have we observed with respect to the dollar volume of retail sales? They have declined for four consecutive months, declining quite substantially (see Chart 3).

Chart 3

In conclusion, falling consumer prices are a symptom of weak consumer demand, not a reason for hope of a rebound in consumer demand. To be sure, if consumer demand is contracting, it is better for consumers that the supply of consumer goods and services is not also contracting. But the circumstance of falling consumer prices would only be "good" for consumers if the decline were being brought about by expanding supply.

Journalists can be excused for writing articles arguing how the current decline in consumer prices is good for consumers. Journalists are not economists. But it is inexcusable that economists would be spreading this malarkey!

By Paul L. Kasriel
The Northern Trust Company
Economic Research Department - Daily Global Commentary

Copyright © 2008 Paul Kasriel
Paul joined the economic research unit of The Northern Trust Company in 1986 as Vice President and Economist, being named Senior Vice President and Director of Economic Research in 2000. His economic and interest rate forecasts are used both internally and by clients. The accuracy of the Economic Research Department's forecasts has consistently been highly-ranked in the Blue Chip survey of about 50 forecasters over the years. To that point, Paul received the prestigious 2006 Lawrence R. Klein Award for having the most accurate economic forecast among the Blue Chip survey participants for the years 2002 through 2005.

The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust Company. The Northern Trust Company does not warrant the accuracy or completeness of information contained herein, such information is subject to change and is not intended to influence your investment decisions.

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