The Trouble With Falling Prices
The ogre stalking the world’s weak economies in recent years wasn’t the one people had learned to fear. The monster wasn’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 can stop spending. It strangles borrowers because their debts get harder to repay — a menace for countries struggling to recover from the 2009 global recession, the worst in a generation. In this fairy tale, inflation comes dressed in shining armor as policy makers debate how to create just enough of it to keep deflation at bay.
Six years after the 2008 financial crisis turned the global economy upside down, a slide in prices threatened to drag out the turmoil. Europe’s economies had failed to recover the momentum needed to stimulate slow-but-steady price increases, which most central bankers consider desirable. The European Central Bank unveiled a bond-buying plan in January 2015 in a once-and-for-all push to revive inflation after euro-area prices fell in December for the first time in more than five years. Denmark, Sweden and Switzerland introduced negative interest rates. The stimulus stopped the rot, helped by a pickup in economic activity in the U.S. and other rich nations. Japan, too, kept up bond buying in an effort to shake off more than a decade of deflation and stagnation, though price gains remained far short of the central bank’s target of 2 percent.
When prices rise at a slower pace it can help consumers boost their purchasing power. Falling prices can also provide a lift if limited and temporary. The drop in oil and other commodity prices in 2014 was praised by some economists as “good deflation” that would open up room for companies and consumers to spend. But when prices actually drop across a wide range of goods and for a long time, economic activity can screech to a halt. 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 corporate and government debt burdens that would otherwise be eroded by inflation. Deflation fueled two of the worst economic disasters in modern times — the 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. The International Monetary Fund studied which economies are vulnerable to deflation, and has raised concern that even a period of ultra-low inflation could do damage. “If inflation is the genie,” IMF Managing Director Christine Lagarde warned in January 2014, “then deflation is the ogre that must be fought decisively.”
Central bankers find it easier to beat inflation than deflation. When prices rise too fast, policy makers 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 were held near zero for years, and the European Central Bank even cut a key rate into negative territory in June 2014. 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 bubbles. Even so, when the threat of deflation seems small, history tells us that it’s a huge risk.
The Reference Shelf
- IMF research on the risk of deflation in the euro area and IMF Managing Director Christine Lagarde’s speech calling deflation an “ogre.”
- 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.
- European Central Bank President Mario Draghi’s February 2014 comments playing down the risk of deflation.
First published March 19, 2014
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