Deflation

The Trouble With Falling Prices

By Simon Kennedy | Updated Jan 14, 2015 12:42 PM EST
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The ogre stalking Europes weak economies isnt the one
people have learned to fear. The monster isnt inflation but
its opposite: falling prices. Its name is deflation and it
appears friendly. Why be afraid when the cash in peoples
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 policy makers
debate how to create just enough of it to keep deflation at
bay.

The Situation

Six years after the 2008 financial crisis turned the

global economy upside down, deflation threatens
to drag out the turmoil in Europe. The continents
economies have failed to recover the momentum
needed to stimulate slow-but-steady price
increases, which most central bankers consider
desirable. Consumer prices in the euro
area fell for the first time in more than five years
in December. The slide in oil is adding to the
deflationary pull and prices are expected
to drop further in 2015. About a third of the goods
that Europeans commonly buy are declining in
price, including clothes and carpets, according
to Jefferies International. In Japan, inflation only
began showing signs of life in 2013 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. Japan fell back into
recession in 2014 and inflation risks slipping anew
after an increase in the consumption tax.

The Background
When prices rise at a slower pace it can help
consumers boost their purchasing power. But
when they actually drop, economic activity can
screech 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 the Great Depression of the
1930s, and the less catastrophic but more recent
experience of Japans 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 has studied which
economies are vulnerable to deflation, and has
raised concern that even a period of ultralow 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.

The Argument
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. Its harder to calibrate the

right dose of medicine to ward off deflation.

Interest rates in most large countries are still
near zero, and the European Central Bank even
cut a key rate intonegative 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. Theyve
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, the ECB
has started buying private-sector assets to boost
prices, and the slide is bolstering the case for
a plan to buy government bonds to add more
stimulus. Even when the threat of deflation seems
small, history tells us that its a huge risk.