Deflation: The Trouble With Falling Prices

25/9/2014 

By Simon Kennedy

The ogre stalking Europe’s weak economy isn’t the one people have learned to fear. The monster isn’t inflation but its opposite: falling prices. Its name is deflation and it appears friendly. Why be afraid when the cash in people’s wallets buys more fuel and televisions, not less? Because when deflation grabs hold, companies and consumers stop spending. It strangles borrowers because their debts get harder to repay — a menace for countries struggling to exit the worst recession in a generation. In this fairy tale, inflation comes dressed in shining armor as policymakers debate how to create just enough of it to keep deflation at bay.

The Situation

Almost six years since the 2008 financial crisis turned the global economy upside-down, deflation threatens to drag out the turmoil in Europe. The continent’s economies have failed to recover the momentum needed to stimulate slow-but-steady price increases, which most central bankers consider desirable. In the euro zone, inflation slid to its weakest rate in almost five years in August, and is stuck at less than a quarter of the European Central Bank’s goal of just below 2 percent. ECB President Mario Draghi raised the alarm when he said investors were increasingly betting on weaker inflation, fanning speculation the central bank may begin buying assets to help generate higher prices. The International Monetary Fund has raised concerns that even a sustained period of ultra-low inflation could do damage. Prices are actually dropping in Italy, Greece and Spain. About a third of the goods in the typical European’s shopping basket are falling in price, including clothes and carpets, according to Jefferies International. In Japan, inflation only began showing signs of life last year as the central bank targeted a 2 percent price gain in an all-out bet to shake off more than a decade of deflation and stagnation. “If inflation is the genie,” IMF Managing Director Christine Lagarde warned in January, “then deflation is the ogre that must be fought decisively.”

The Background

Having prices go up more slowly helps consumers and can boost purchasing power. But when they actually drop, economic activity screeches to a halt. Households hold off making purchases as they anticipate further price declines; companies postpone investment and hiring as they are forced to cut prices. Sliding prices eat into sales and tax receipts, limiting pay raises and profit margins. They add to the debt burdens of companies and governments that would otherwise be eroded by inflation. Deflation fueled two of the worst economic disasters in modern times — America’s Great Depression of the 1930s, and the less catastrophic but more recent experience of Japan’s lost decades with almost no economic growth.  Deflation took hold in Japan in the 1990s when banks, wounded by a burst real estate bubble, stopped lending. Wages stagnated and consumers reined in spending. Last year, the country turned to an unprecedented strategy of monetary easing and government spending dubbed Abenomics after Prime Minister Shinzo Abe vowed to finally jolt Japan out of its slump.
The Argument

Central bankers find it easier to beat inflation than deflation. When prices rise too fast, they raise interest rates, then pull back when the economy slows. It’s harder to calibrate the right dose of medicine to ward off deflation. Interest rates in most large countries are still near zero, and the ECB even cut a key rate into negative territory in June. In Greece, deflation may be a price worth paying to make the country competitive again after years of living beyond its means. Bond-buying programs like those that helped revive the U.S. and Japan have also had dangerous side effects. They’ve sent money flowing into stocks and property, boosting the prices of assets rather than products, raising concern that too much easing was creating dangerous bubbles. Even so, Europe is considering a similar move to ensure it keeps deflation at bay. Even when the threat of deflation seems small, history tells us that it’s a huge risk.

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