El-Erian Warns: Don't Expect Prices to Fall, Despite Cooling Inflation

Waiting for prices to settle and things to go back to how they were/? Don’t hold your breath, Mohamed El-Erian, president of Queens’ College, Cambridge; chief economic adviser at Allianz SE; chair of Gramercy Fund Management; and former chief executive officer of Pimco, effectively suggested on CBS’s Face the Nation on Sunday.

“Most of the report … was distorted in a really important manner by the strikes, by the hurricanes,” El-Erian said of the jobs report that came out last Friday. “We have an economy that has been growing robustly, inflation is coming down, and the main challenge for the next administration is not just to maintain what is called ‘economic exceptionalism,’ because we’re outperforming all other advanced economies, but also to continue to reposition it for the engines of tomorrow’s prosperity, and that’s absolutely critical.”

Straight ahead so far, but El-Erian has demonstrated economic caution over time. Face the Nation’s Margaret Brennan, noting that the Federal Reserve could potentially cut rates again on Thursday during the Federal Open Market Committee meeting as inflation has continued to flow, asked about prices.

“For average people, they see housing prices are high, they see grocery prices are still high, where’s the scenario where those prices actually come down,” Brennan asked.

El-Erian smiled for a second and said, “Yeah, and that’s what everyone’s expecting, but it’s not going to happen. Look, the good news is interest rates will continue to come down. The good news is inflation, which is the rate of increase of the cost of living, will come down. But it’s very hard to bring down prices. And that’s one political problem. When you tell people inflation’s coming down, in their head, they think prices are coming down, not the rate of increase of prices. So, it’s a misunderstanding, unfortunately, but you’ve got to be careful what you wish for because if prices come down significantly, we are then in something much worse economically.”

Brennen didn’t ask, but there is a standard economic answer to the question that should have been there: Why are falling prices bad?

It’s not that falling prices inherently are bad. The economic explanation focuses on what happens when prices begin a process of falling. People see prices coming down and eventually, some if not most, decide to delay purchases to see how much further prices can come.

This can begin a so-called deflation spiral. There are multiple ways this sort of dynamic can start. The applicable one here is that people begin to expect falling prices for products and services, so they hold onto their money and wait. Resellers and vendors drop prices to attract buyers, who now wait longer to save even more on purchases.

This builds excess supply and sets off further price cuts and more waiting. Companies that aren’t making enough sales begin cutting costs, including laying off staff. There’s a sharp increase in unemployment, the public gets scared and holds on more tightly to their money, and businesses start going under. Credit gets tighter.

The last time this happened was in the 1930s, due to bank failures and a resulting fall in the money supply — another type of trigger, as is when economic output grows faster than circulating money and credit. The ultimate result was the Great Depression.

Outside of the concern, from a practical view, vendors of products and services likely don’t see a need to cut prices and profits as well.