Over the last few months, we’ve been hearing a lot about inflation. In fact, it has been the main preoccupation for the Federal Reserve for some time and has led to repeated hikes of interest rates as the central bank attempts to bring inflation under control.
You may only be vaguely aware of it, but inflation has a cousin. Deflation. What is deflation you may ask? If it’s the opposite of inflation, and inflation is bad, then surely deflation is a good thing? In fact, inflation, though it causes many problems, is not as bad for the economy as deflation.
What is deflation?
Fundamentally, deflation refers to a sustained decline in the general cost of goods or services within an economy across a time period.
Inflation, the well-known opposite of deflation, is a prolonged rise in the overall level; this is something that most business sectors have had to contend with over the past few months.
When the supply of services and goods in an economy outstrips its demand, deflation is thought to exist. This results in a decline in the average price of goods and services, and the decline in the economy’s overall level of prices reduces the buying power of money.
Good deflation vs bad deflation
During the recession, economic experts warned not of deflation, but of runaway inflation, as a result of government stimulus, record-low rates of interest and the Federal Reserve’s injection of over $1tn in fresh money into the economy.
In a typical economy, all this liquidity would increase asset demand, resulting in price increases and inflation. Unfortunately, the current circumstances are exceptional. Numerous consumers are unemployed, with declining or no income. Many consumers cannot borrow even if they wanted to, and household spending is declining as a result.
Some deflation can be considered as ‘good’. The microprocessor revolution, for example, has driven down the cost of computers, televisions and other kinds of electronics, while growing imports from low-cost countries such as China has made clothing, furniture and appliances cheaper. Economists call this “good deflation”, because it makes people and companies more productive and helps improve living standards.
Bad deflation occurs when the prices of all goods and services decline. This harms everyone. Typically, a span of deflation is preceded by financial crisis, severe recession and an increase in unemployment. We have experienced all of these in recent years.
When the economic downturn is severe enough, the demand for all goods falls significantly below supply, because people simply cannot afford to buy all the goods that businesses are prepared to produce. If all prices decline, this can be a disaster for the general economy. A general fall in prices results in decreased profits and revenues for businesses, which leads to layoffs, reduced hiring, wage stagnation and outright wage reductions.
Shoppers with lower salaries have less disposable income, which locks the deflationary cycle in place. As sales decline, businesses must reduce prices even further to attract customers. The worst part is when everyone realizes that prices are dropping because no one will purchase an item today when it may be lower in price tomorrow.
Additionally, deflation causes chaos for regular borrowing and other normal economic functions. As the value of fixed debt decreases over time, inflation alleviates the debt burden for individuals. In contrast, deflation causes debt to become more costly over time. If deflation is at 4% per year and your income decreases at the same speed, the monthly mortgage would consume a larger portion of your income.
Deflation causes cash to become an extremely valuable asset, as a 0% return is preferable to a negative one. There is no incentive for banks to provide loans, as they would incur losses. The default rate would soar, exacerbating the existing problems of bankrupt consumers, money-losing banks and frozen credit. Everyone would stockpile cash, and customers would only purchase the bare necessities.
Summary
These are unusual economic times, but it is clear that the risk of deflation is more of a threat to the overall economy than inflation. Navigating a course between these two problems will take considerable ingenuity from central banks and all businesses will have to be flexible and agile to cope with the turbulence.