Could deflation be next?

Let's hope not.

The stock market meltdown is mostly an ominous signal about stalling global growth and the rising risks of a sovereign debt and bank credit crisis in Europe. Political gridlock in Washington and the federal government's loss of its Tripe-A status doesn't help.

If that weren't nerve-wracking enough, the global economy is at risk to a downward deflationary spiral. For example, in the U.S. the major price indices are sinking toward the 1% level. If another bout of economic weakness, higher unemployment, and lower equity and home values emerge out of the turmoil they could combine into a vicious cycle of falling prices, or deflation.

Deflation is so dangerous in a weak economy because it raises the real cost of borrowing. It also increases the real cost of paying worker wages. The net result is that companies borrow less and lay off more workers with every downward tick in the deflation rate and, at the same time, less borrowing and more layoffs leads to even less economic activity and additional prices declines. The normal economic relationships fall apart when deflation is combined with an economic downturn. .

The Federal Reserve has a limited monetary arsenal to combat deflation. Yet the Fed is the only game in town. The levers of fiscal policy are probably better at combatting deflationary forces, but not when political gridlock holds sway in Washington. There is always the hope that the market trauma will bring sober realism to the political class. We'll see.

Many economists on Wall Street, in Washington, and the European Union have worried about inflation, or rising prices. The refrain has been that the Fed's loose monetary policy to fight the Great Recession will end in a severe bout of high and rising inflation reminiscent of the double-digit era of the 1970s. It's time to abandon the fear of inflation. It's the forces of deflation that have been gathering momentum.

The good news is that we aren't at deflation yet.

Here's one way to look think through your take on prices and the economy. The estimated S&P 500 dividend yield is 2.34%. The yield on the 10 Year Treasury is 2.33%.

If you're attracted to stocks you believe the dividend yield is signaling the market panic has gone too far and the economic recovery remains intact (even if weaker than hoped for). If you like bonds at 2.33% you feel the odds of another recession and deflation is high. We should get a better inkling over which message in which market to pay attention to over the next few days and weeks.

About the author

Chris Farrell is the economics editor of Marketplace Money.

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