Unstable times cause unstable prices. In mid-April, the price of oil fell briefly below zero for the first time ever, a warning sign of severe deflation. On the other hand, meat-plant closures and constraint on farmworkers’ movements are warning signs of potential inflation, as shortages push up prices for basic staples. The federal government, through both congressional and Federal Reserve action, is taking unprecedented measures to try to prevent both inflation and deflation—but it must take care not to thwart the ability of specific markets, from Manhattan real estate to airline capacity, to adjust to new realities.
It’s natural to think of sharp inflation and stark deflation as opposites, but they’re similar in some ways: big movements in the market value of goods, services, and assets, and their increasing unaffordability to large sectors of the population. A deflationary spiral followed the 1929 stock market crash. As stock market and real-estate values crashed, banks—burned by losses—stopped lending. Investors harmed by falling prices stopped spending. The plunge in demand and constrained access to debt forced even viable businesses to cut staff and pay. In turn, workers earning less money, or nothing at all, had less to spend, further pushing down prices.
Five decades later, oil-price shocks stemming from Middle East unrest helped cause double-digit inflation, as the Federal Reserve printed money to help people keep up with rising costs. This, too, turned into a self-fulfilling prophecy: investors demanded higher interest rates on loans to account for the higher inflation, which curtailed economic activity. Workers, knowing that the price of goods would go up, demanded higher pay, further pushing up the price of goods—and so on.
Economists differ on which is worse: inflation or deflation. If you lived through a severe deflation, as Depression-era economists did, you likely err on the side of inflation. If you lived through a severe inflation, as in the late 1970s, you probably prefer deflation. But economists, in worrying about the price of day-to-day goods and services, tend to neglect asset prices. The Federal Reserve and academic watchdogs virtually ignored the stock-market bubble of the late 1990s and the real-estate bubble of the early 2000s, as the stable price of staple goods and services—in large part due to cheap imports from China and cheap labor from Mexico—kept them complacent.
The economic path ahead is uncertain, to say the least. One possibility is that everything will soon be fine: Covid-19 goes away, people flock back to work, school, and recreational activities, and the trillions of dollars in federal rescue money proves to have been the right amount to replace lost GDP. The other, less hopeful scenario is a combination of both deflation and inflation. Across the economy, businesses and individuals—short of adequate federal rescue money to replace lost income and jobs—stop paying for less essential goods and services such as vacations and restaurant meals. Without rent coming in, the value of retail, hotel, and commercial real estate falls; owners, in turn, cut their losses and walk away from their properties. Distressed homeowners start defaulting on their mortgages; would-be homeowners can’t afford pre-crisis prices, further depressing values. Meantime, the inflationary scenario: even as core goods such as meat and produce become scarcer, consumers use their remaining income—with unemployment benefits, for people earning up to the mid-five figures, replacing lost wages—to bid up the price of these necessary goods as they cut spending on anything discretionary. Overall, if federal rescue falls far short of lost income across the economy, even people who continue to earn a comfortable living will use their remaining resources not to splurge but to try to keep the pantry stocked and to save money, as they, too, absorb economic anxiety.
Congress and the Fed—with the trillions of dollars’ worth of actions they’ve taken so far—risk exacerbating the risk of extreme price movements rather than alleviating that risk. That’s unavoidable. It would be worse to do nothing and watch political and social conditions deteriorate further. But the Fed at least should learn from recent history. Before 2008, the central bank confined its activities to buying and selling federal-government bonds, thereby increasing or decreasing overall interest rates. After 2008, the Fed began interfering directly in mortgage-bond and corporate-bond markets, buying and selling mortgage-backed securities and lending to financial firms that purchased high-quality corporate and other bonds. Now, the Fed is increasing all these activities by an order of magnitude, likely expanding its direct interference in corporate-bond markets by trillions. Through complex machinations, the central bank will now indirectly purchase debt backed by almost anything—from idle cruise ships and airplanes to empty Manhattan condo and office towers.
The danger here is that in lending cheaply to the financial industry, the Fed just enables finance to trade these assets at artificially high prices, or to hold these assets on their books at inflated prices. This has already happened over the last decade, with developers borrowing to build near-empty condo towers, and excess office space, all over Manhattan. Before Covid-19, 15 percent of residential real estate in core Manhattan—more than 55,000 units—stood vacant. The vacancy rate for Midtown office space was 10.4 percent.
In indiscriminately propping up asset values through cheap debt, the Fed thwarts certain markets’ price adjustments to new conditions. If businesses balk at paying high prices for office space in dense Manhattan, and if global investors no longer think an empty apartment in Manhattan is a safe haven, prices should fall, and developers should incur losses. Likewise, if the cruise and airline industries must shrink indefinitely to account for lower demand, such shrinkage must happen sooner rather than later; otherwise, airlines competing against one another in an environment of overcapacity only lose money. Lower prices for office rents, residential rents, and condos will spur people to take a risk on working or living in Manhattan, rather than giving up on it. Likewise, a smaller, stronger airline industry can grow again as demand returns.
By artificially inflating asset prices, the Fed also takes pressure off Congress to provide more rescue dollars to people who have lost jobs and income. Thus, Washington risks not just the bad-enough combination of deflation in asset prices and inflation in the price of basic goods and services, but an even worse one-two punch: deflation in the price of basic goods, as many people can’t even afford food; and inflation in asset prices, as financial firms, with cheap Fed money, can afford to buy up trillions of dollars’ worth of houses, apartments, and office buildings at artificially high prices.
Adjusting to a post-coronavirus world will be painful. Washington should be careful not to make it worse.