While decreased prices may appear to be a good thing, deflation can have a negative impact on the economy, such as when it leads to high unemployment, and can turn a poor situation, such as a recession, into a worse scenario, such as a depression.
How does deflation exacerbate a recession?
Deflation generally heralds the start of a recession. A recession brings lower earnings, job losses, and significant losses to most financial portfolios. Deflation increases as a recession worsens. Businesses advertise ever-lower pricing in an attempt to persuade customers to acquire their goods and services.
What are the three consequences of deflation?
A drop in aggregate demand can also be caused by negative economic events, such as a recession. During a recession, for example, people may become more pessimistic about the economy’s future. As a result, they prefer to expand their savings while cutting back on current consumption.
Deflation can also be triggered by an increase in aggregate supply. As a result, companies will face more intense competition and will be pushed to cut their prices. The following variables can contribute to an increase in aggregate supply:
Lower production costs
Production expenses will be reduced if the price of essential production inputs (such as oil) falls. Producers will be able to expand production output, resulting in an economic oversupply. If demand stays the same, companies will have to cut their prices to keep customers buying their products.
Technological advances
A rise in aggregate supply can be caused by technological advancements or the quick implementation of new technologies in production. Producers will be able to cut expenses thanks to technological advancements. As a result, product prices are likely to fall.
Increase in the real value of debt
Deflation is related with an increase in interest rates, which causes the real worth of debt to increase. As a result, buyers are more prone to postpone their purchases.
Deflation spiral
This is a scenario in which falling prices set off a chain reaction that results in lesser production, lower salaries, lower demand, and even lower prices. The deflation spiral is a serious economic challenge during a recession since it worsens the economic situation.
When there is deflation, what happens to the economy?
There has been a spike of interest in deflation as the US inflation rate approaches zero and the economy hits a “soft patch” between late 2002 and the first half of 2003. Concerns are also raised by Japan’s protracted deflationary period and poor economic performance. In the figure below, time periods when the Consumer Price Index (CPI) change was negative show deflation, which is defined as an usually dropping price level. The graphic demonstrates that deflation has been relatively uncommon in the United States; the most severe period of deflation in the last 80 years happened in the early 1930s during the Great Depression. Despite multiple recessions since the 1930s (shown as shaded gray bars on the image), the last time the CPI fell for a brief period was in the 1950s.
Most economists regarded deflation as a low-probability scenario in 2003. However, in the event of a substantial negative economic shock, the weak economic expansion from late 2002 to mid-2003 boosts the possibility that the economy may enter a period of deflation. Concern arises because deflation has the potential to have severe negative consequences for the economy. Furthermore, even decreasing interest rates to zero may not be sufficient to return the economy to full employment.
“In other words, deflation discourages borrowing and spending, both of which are necessary for a depressed economy to recover.”
Because prices will be lower and purchasing power will be greater in the future, deflation promotes incentives to save and postpone consumption. This tendency has a negative impact on expenditure and the economy. At the same time, deflation exacerbates borrowers’ debt repayment responsibilities, as the cost of repaying debt rises with deflation. This is because, during deflations, debts remain unchanged in dollar terms, but wages and income often fall. Japan is a living illustration of the negative impacts of deflation on a country’s economy. (See “Preventing Deflation: Lessons from Japan’s Experience in the 1990s,” International Finance Discussion Papers.) )
Chairman Greenspan’s address on December 19, 2002, titled “Issues for Monetary Policy,” adds to the growing body of knowledge about the devastating impact of deflation on debtors’ financial health and labor market conditions:
After years of successful attempts to lower the pace of inflation in the United States, authorities expressed alarm in late 2002 about a new threat: deflation. Members of the Federal Open Market Committee emphasized the topic again in their May 6, 2003 Statement, writing that the economy faced a tiny but real risk of deflation. The combination of low U.S. inflation and a sluggish economy contributed to this shift in focus. Meanwhile, policymakers were looking into ways to prevent deflation from occurring in the first place, which is the desired scenario, and to combat deflation once it has begun, which is a far more difficult undertaking once an economy has entered a deflationary spiral.
With his November 21, 2002 lecture on the subject, Federal Reserve Governor Ben S. Bernanke helped to focus policymakers and economists on the issue of deflation. His remarks at the National Economists Club in Washington, D.C. were headed “Deflation: Making Sure “It” Doesn’t Happen Here.” His remarks, which were widely reported in the press, focused on a number of strategies for combating deflation.
- Describe some possible policies for dealing with deflation if it occurs in a given economy.
A general drop in prices is defined as deflation, with the emphasis on the word “general.” Deflation happens when price decreases are so pervasive that broad-based price indexes, such as the consumer price index, continue to show falls.
The causes of deflation are well-known. Deflation is nearly always a side consequence of a substantial reduction in aggregate demand, which forces firms to cut prices on a regular basis in order to find buyers.
The basic prescription for avoiding deflation is thus simple, at least in principle: use monetary and fiscal policy to support aggregate spending in a way that is as close to full utilization of economic resources as possible while maintaining low and stable inflation. To put it another way, the greatest approach to avoid getting into trouble is to avoid getting into it in the first place. Beyond this reasonable directive, however, the Fed (or any other central bank) can take a number of steps to lessen the risk of deflation.
First, the Fed should aim to maintain an inflation rate buffer zone, meaning that it should not try to push inflation all the way to zero during normal times.
Second, the Fed should take its role to guarantee financial stability in the economy very seriously, as it already does.
Third, as a number of studies have suggested, when inflation is already low and the economy’s fundamentals suddenly deteriorate, the central bank should act more forcefully than normal in decreasing rates.
As I have stated, I believe that the combination of strong economic fundamentals and policymakers who are aware of both downside and upside risks to inflation makes serious deflation in the United States improbable in the near future. But assume that, despite all measures, deflation sets in in the United States, and that the Federal Reserve’s policy tool, the federal funds rate, falls to zero. So, what’s next?
In the remainder of my presentation, I’ll go over some strategies for preventing a deflation once it’s started. I should point out that my views on this subject are inevitably theoretical, given the contemporary Federal Reserve has never faced a situation like this and has never publicly committed itself to a certain course of action if deflation occurs.
Normally, the Federal Reserve injects money into the economy by purchasing assets. When short-term interest rates near zero, the Fed must either increase the size of its asset purchases or, more likely, expand the types of assets it acquires. Alternatively, the Fed might find alternative ways to inject money into the economy, such as offering low-interest loans to banks or collaborating with the government.
So, what would the Fed do if the overnight federal funds rate, which is the Fed’s main interest rate, went to zero? One relatively simple expansion of present methods would be to cut rates further out along the Treasury term structure, that is, rates on government bonds with longer maturities, in order to boost expenditure.
Although a policy of intervening in the dollar’s exchange rate isn’t on the cards right now, it’s worth noting that exchange rate regulation has been an effective tool against deflation in the past.
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Each of the policy choices I’ve described thus far requires the Fed to act independently. Cooperation between the monetary and fiscal authorities could greatly improve the effectiveness of anti-deflation policies in practice. A broad-based tax cut, for example, accompanied by a program of open-market purchases to counteract any rise in interest rates, would almost likely be an effective stimulant to consumption and thus prices.
Of course, instead of tax cuts or transfers, the government may increase spending on current goods and services or even buy real or financial assets.
Who gains from deflation?
- Consumers benefit from deflation in the near term because it enhances their purchasing power, allowing them to save more money as their income rises in relation to their expenses.
- In the long run, deflation leads to greater unemployment rates and can lead to consumers defaulting on their debt obligations.
- The last time the world was engulfed in a long-term phase of deflation was during the Great Depression.
What happens to property values in a deflationary environment?
Your dollar would be worth 95% less today than it was in 1915 if you kept it in cash for the previous 100 years. This is due to the fact that the value of your money depreciates over time and may buy you less each year due to inflation.
Debt operates in a similar way. In nominal terms, the debt’s worth does not change (assuming you do not pay it off). However, the value of that loan depreciates over time in the same manner that currency does. In today’s dollars, $100 in debt would be worth less than $10 over the last 100 years. This is why using leverage during inflationary periods is so valuable. It lowers the value of your loan over time.
Deflation is different when it comes to debt
While inflation gradually erodes the value of debt, deflation has the reverse effect. It increases the debt’s value over time. This is how a mortgage can deplete your property value. Here’s another look at one of the graphs from before.
While the cost of goods and services is falling, the cost of debt is staying the same. In fact, it improves in contrast. This is why, if there is a negative inflation rate, it is critical to minimize or erase your debt.
Help me! Deflation is confusing
It can be difficult to understand the distinction between future dollars and today’s dollars. Especially if we haven’t dealt with deflation before. Another approach to demonstrate how deflation can effect your investment property mortgage is to consider the following scenario:
Let’s imagine you wanted to buy an investment property for $125,000 today and decided to take out a $100,000 mortgage on it. Most mortgage contracts are relatively similar in that, depending on the sort of mortgage you have, you must make either fixed or variable installments.
In this case, there is no inflation, but the bank adds $3,000 to the balance of your mortgage each year, in addition to any interest payments you due. You would pay the interest due at the conclusion of year one, and your principal sum would be boosted to $103,000. Do you find this to be an appealing proposition?
This means that if you have a 3% interest rate, you will owe a net of 6% every year. 3% in interest and 3% extra on top of the principal.
Hopefully, you’ve realized that while you’re employing leverage, deflation hurts a lot.
To summarize, when there is deflation, the value of your real estate declines, your cash flows drop, and if you are utilizing leverage, those drops are compounded. Remember, if there is deflation, you should not have a mortgage.
We have had inflation for over 50 years, why should you worry about deflation?
We can assume that if housing prices are a good hedge against inflation, they will also be a strong hedge against deflation. However, why should we be concerned about deflation?
What can you get during a deflationary period?
Companies that supply products or services that we can’t easily cut out of our lives are considered defensive stocks. Two of the most common examples are consumer products and utilities.
Consider toilet paper, food, and power. People will always require these commodities and services, regardless of economic conditions.
You may invest in ETFs that track the Dow Jones U.S. Consumer Goods Index or the Dow Jones U.S. Utilities Index if you don’t want to invest in specific firms.
iShares US Consumer Goods (IYK) and ProShares Ultra Consumer Goods are two prominent consumer goods ETFs (UGE). iShares US Utilities (IDU) and ProShares Ultra Utilities (PUU) are two ETFs that invest in utilities (UPW).
Is deflation ever beneficial?
This general price decrease is beneficial since it offers customers more purchasing power. Moderate price cuts in certain products, such as food or energy, can have a favorable influence on nominal consumer expenditure to some extent. A general, sustained drop in all prices, in addition to allowing people to consume more, can support economic growth and stability by improving the function of money as a store of value and encouraging genuine saving.
How does deflation benefit you?
- Investors must take efforts to protect their portfolios against inflation or deflation, that is, whether prices for goods and services are growing or declining.
- Growth stocks, gold, and other commodities are all good inflation hedges, as are foreign bonds and Treasury Inflation-Protected Securities for income investors.
- Investment-grade bonds, defensive equities (those of consumer goods companies), dividend-paying stocks, and cash are all strong deflation hedges.
- Regardless of what happens in the economy, a diversified portfolio that contains both types of assets can provide some security.