Deflation occurs when asset and consumer prices fall over time. While this may seem like a great thing for shoppers, the actual cause of widespread deflation is a long-term drop in demand.
Deflation often signals an impending recession. With a recession comes declining wages, job losses, and big hits to most investment portfolios. As a recession worsens, so does deflation. Businesses hawk ever-lower prices in desperate attempts to get consumers to buy their products and services.
- Deflation is when the prices of goods and services fall.
- Deflation expectations make consumers wait for future lower prices. That reduces demand and slows growth.
- Deflation is worse than inflation because interest rates can only be lowered to zero.
- Innovation can cause good deflation.
Measuring the Decline
Deflation is measured by a decrease in the Consumer Price Index. But the CPI does not measure stock prices, an important economic indicator. For example, retirees use stocks to fund purchases. Businesses use them to fund growth.
In other words, when the stock market drops, the CPI might be missing one important indicator of deflation as it's felt in people's pocketbooks. Comprehensive awareness of this economic indicator is important for effectively gauging whether or not a dramatic dip in the stock market will cause a recession.
Neither does the CPI include sales prices of homes. Instead, it calculates the "monthly equivalent of owning a home," which it derives from rents. This is misleading since rental prices are likely to drop when there is a high vacancy. That's usually when interest rates are low and housing prices are rising. Conversely, when home prices are dropping due to high-interest rates, rents tend to increase.
CPI figures can provide a false low reading when home prices are high and rents are low.
This is why asset inflation during the housing bubble of 2006 went essentially unnoticed. Had it been a focus, the Federal Reserve could have raised interest rates in an attempt to prevent the bubble. Such a strategic response might have also mitigated some of the pain when the bubble burst in 2007.
There are three reasons why deflation exists as a greater threat than inflation since 2000.
First, exports from China have kept prices low. The country has a lower standard of living, so it can pay its workers less. China also keeps its exchange rate pegged to the dollar, which keeps its exports competitive.
Second, in the 21st century, technology such as computers keeps workers' productivity high. Most information can be retrieved in seconds from the internet. Workers don't have to spend time tracking it down. The switch from snail mail to email streamlined business communications.
Third, the excess of aging baby boomers allows corporations to keep wages low. Many boomers have remained in the workforce because they can't afford to retire. They are willing to accept lower wages to supplement their incomes. These lower costs mean companies haven't needed to raise prices.
Deflation's Cautionary Tale
Deflation slows economic growth. As prices fall, people put off purchases. They hope they can get a better deal later. You've probably experienced this yourself when thinking about getting a new cell phone, iPad, or TV. You might wait until next year to get this year's model for less.
This puts pressure on manufacturers to constantly lower prices and develop new products. That's good for consumers like you. But constant cost-cutting means lower wages and less investment spending. That's why only companies with a fanatic, loyal following, like Apple, really succeed in this market.
As unemployment rose, demand for goods and services fell. The Consumer Price Index fell 27% between November 1929 to March 1933, according to the Bureau of Labor Statistics. As prices fell, companies went out of business. More people became unemployed.
When the dust settled, world trade had essentially collapsed. The volume of goods and services traded fell 67%, from $3 billion in 1929 to $992 million in 1933.
How It’s Stopped
To combat deflation, the Federal Reserve stimulates the economy with expansionary monetary policy. It reduces the fed funds rate target and buys Treasurys using its open market operations. When needed, the Fed uses other tools to increase the money supply. When it increases liquidity in the economy, people often wonder whether the Fed is printing money.
Our elected officials can also offset falling prices with discretionary fiscal policy, or lowering taxes. They can also increase government spending. Both create a temporary deficit. Of course, if the deficit is already at record levels, discretionary fiscal policy becomes less popular.
Why does expansionary monetary or fiscal policy work in stopping deflation? If done correctly, it stimulates demand.
With more money to spend, people are likely to buy what they want as well as what they need. They'll stop waiting for prices to fall further. This increase in demand will push prices up, reversing the deflationary trend.
Why Deflation Is Worse than Inflation
The opposite of deflation is inflation. Inflation is when prices rise over time. Both economic responses are very difficult to combat once entrenched because people's expectations worsen price trends. When prices rise during inflation, they create an asset bubble. This bubble can be burst by central banks raising interest rates.
Former Fed Chairman Paul Volcker proved this in the 1980s. He fought double-digit inflation by raising the fed funds rate to 20%. He kept it there even though it caused a recession. He had to take this drastic action to convince everyone that inflation could actually be tamed. Thanks to Volcker, central bankers now know the most important tool in combating inflation or deflation is controlling people's expectations of price changes.
Deflation is worse than inflation because interest rates can only be lowered to zero.
Once rates have hit zero, central banks must use other tools. But as long as businesses and people feel less wealthy, they spend less, reducing demand further. They don't care if interest rates are zero because they aren't borrowing anyway. There's too much liquidity, but it does no good. It's like pushing a string. That deadly situation is called a liquidity trap and is a vicious, downward spiral.
The Rare Times When Deflation Is Good
A massive, widespread drop in prices is always bad for the economy. But deflation in certain asset classes can be good. For example, there has been ongoing deflation in consumer goods, especially computers and electronic equipment.
This isn't because of lower demand, but from innovation. In the case of consumer goods, production has moved to China, where wages are lower. This is an innovation in manufacturing, which results in lower prices for many consumer goods. In the case of computers, manufacturers find ways to make the components smaller and more powerful for the same price. This is technological innovation. It keeps computer manufacturers competitive.
Japan: A Modern Example
Japan's economy has been caught in a deflationary spiral for the past 30 years. It started in the late 1980s when Japan's housing bubble burst. Japanese people became savers. When they saw the signs of recession, they stopped spending and put away funds for bad times. They assumed that wages and prices will not rise, so it's better to save. Banks invested the extra funds in government debt instead of new business ventures.
A study by Daniel Okimoto at Stanford University identified four other factors contributing to this longstanding spiral:
- The political party in power did not take the difficult steps needed to spur the economy.
- Taxes were raised in 1997.
- Banks kept bad loans on their books. This practice tied up the capital needed to invest in growth.
- The yen carries trade kept the value of Japan's currency high relative to the dollar and other global currencies. The Bank of Japan tried to create inflation by lowering interest rates. But traders took advantage of the situation by borrowing yen cheaply and investing it in currencies with a higher return.