The ogre stalking the globe’s weak economies 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.
Almost six years since the 2008 financial crisis turned the global economy upside-down, deflation threatens to drag out the turmoil. Most developed 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 is stuck at less than half the central bank’s 2 percent goal and there’s rising concern at the International Monetary Fund that even a sustained period of ultra-low inflation could do damage. Prices are dropping in Greece and Spain. About a fifth of the goods in the typical European’s shopping basket are falling in price, including clothes and carpets, according to Jefferies International. 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. 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. Providing a further dose of concern is slowing growth in emerging markets such as China and Brazil, which is dragging down prices of commodities like copper. “If inflation is the genie,” IMF Managing Director Christine Lagarde warned in January, “then deflation is the ogre that must be fought decisively.”
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. 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.
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. Right now, interest rates can’t be cut in most large countries because they’re already near zero. Government bond-buying programs 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 concerns that too much easing was creating dangerous bubbles. Policymakers in deflation-prone regions like Europe may be willing to take their chances for now as the economy picks up and further steps to stimulate growth could be an overreaction. In Greece, deflation may be a price worth paying to make the country competitive again after years of living beyond its means. Even when the chances of deflation are small, though, history tells us that it’s a huge risk.
The Reference Shelf
- Former U.S. Federal Reserve Chairman Ben S. Bernanke’s 2002 speech on deflation and his 1991 research paper on the Great Depression.
- Studies from a 2003 symposium on deflation hosted by the Federal Reserve Bank of Minneapolis.
- IMF research on the risk of deflation in the euro area and IMF Managing Director Christine Lagarde speech calling deflation an “ogre.”
- Europen Central Bank President Mario Draghi’s Feb. 6 comments playing down the risk of deflation.