- Consumers anticipate reduced prices in the future as a result of deflation expectations. As a result, demand falls and growth decreases.
- Because interest rates can only be decreased to zero, deflation is worse than inflation.
Isn’t deflation always preferable to inflation?
1. Deflation (price declines negative inflation) is extremely dangerous. People are hesitant to spend money while prices are falling because they believe items will be cheaper in the future; as a result, they continue to postpone purchases. Furthermore, deflation raises the real worth of debt and lowers the disposable income of people who are trying to pay off debt. When consumers take on debt, such as a mortgage, they typically expect a 2% inflation rate to help erode the debt’s value over time. If the 2% inflation rate does not materialize, their debt burden will be higher than anticipated. Deflationary periods wreaked havoc on the UK in the 1920s, Japan in the 1990s and 2000s, and the Eurozone in the 2010s.
2. Wage adjustments are possible due to moderate inflation. A moderate pace of inflation, it is thought, makes relative salary adjustments easier. It may be difficult, for example, to reduce nominal wages (workers resent and resist a nominal wage cut). However, if average wages are growing due to modest inflation, it is simpler to raise the pay of productive workers; unproductive people’ earnings can be frozen, effectively resulting in a real wage reduction. If there was no inflation, there would be greater real wage unemployment, as businesses would be unable to decrease pay to recruit workers.
3. Inflation allows comparable pricing to be adjusted. Moderate inflation, like the previous argument, makes it easier to alter relative pricing. This is especially significant in the case of a single currency, such as the Eurozone. Countries in southern Europe, such as Italy, Spain, and Greece, have become uncompetitive, resulting in a high current account deficit. Because Spain and Greece are unable to weaken their currencies in the Single Currency, they must reduce comparable prices in order to recover competitiveness. Because of Europe’s low inflation, they are forced to slash prices and wages, resulting in decreased growth (due to the effects of deflation). It would be easier for southern Europe to adjust and restore competitiveness without succumbing to deflation if the Eurozone had modest inflation.
4. Inflation can help the economy grow. The economy may be locked in a recession during periods of exceptionally low inflation. Targeting a higher rate of inflation may theoretically improve economic growth. This viewpoint is divisive. Some economists oppose aiming for a higher inflation rate. Some, on the other hand, would aim for more inflation if the economy remained in a prolonged slump. See also: Inflation rate that is optimal.
For example, in 2013-14, the Eurozone experienced a relatively low inflation rate, which was accompanied by very slow economic development and high unemployment. We may have witnessed a rise in Eurozone GDP if the ECB had been willing to aim higher inflation.
The Phillips Curve argues that inflation and unemployment are mutually exclusive. Higher inflation reduces unemployment (at least in the short term), but the significance of this trade-off is debatable.
5. Deflation is preferable to inflation. Economists joke that the only thing worse than inflation is deflation. A drop in prices can increase actual debt burdens while also discouraging spending and investment. The Great Depression of the 1930s was exacerbated by deflation.
Disadvantages of inflation
When the inflation rate exceeds 2%, it is usually considered a problem. The more inflation there is, the more serious the matter becomes. Hyperinflation can wipe out people’s savings and produce considerable instability in severe cases, such as in Germany in the 1920s, Hungary in the 1940s, and Zimbabwe in the 2000s. This type of hyperinflation, on the other hand, is uncommon in today’s economy. Inflation is usually accompanied by increased interest rates, so savers don’t lose their money. Inflation, on the other hand, can still be an issue.
- Inflationary expansion is often unsustainable, resulting in harmful boom-bust economic cycles. For example, in the late 1980s, the United Kingdom experienced substantial inflation, but this economic boom was unsustainable, and attempts by the government to curb inflation resulted in the recession of 1990-92.
- Inflation tends to inhibit long-term economic growth and investment. This is due to the increased likelihood of uncertainty and misunderstanding during periods of high inflation. Low inflation is said to promote better stability and encourage businesses to invest and take risks.
- Inflation can make a business unprofitable. A significantly greater rate of inflation in Italy, for example, can render Italian exports uncompetitive, resulting in a lower AD, a current account deficit, and slower economic growth. This is especially crucial for Euro-zone countries, as they are unable to devalue in order to regain competitiveness.
- Reduce the worth of your savings. Money loses its worth as a result of inflation. If inflation is higher than interest rates, savers will be worse off. Inflationary pressures can cause income redistribution in society. The elderly are frequently the ones that suffer the most from inflation. This is especially true when inflation is strong and interest rates are low.
- Menu costs – during periods of strong inflation, the cost of revising price lists increases. With modern technologies, this isn’t as important.
- Real wages are falling. In some cases, significant inflation might result in a decrease in real earnings. Real incomes decline when inflation is higher than nominal salaries. During the Great Recession of 2008-16, this was a concern, as prices rose faster than incomes.
Inflation (CPI) outpaced pay growth from 2008 to 2014, resulting in a drop in living standards, particularly for low-paid, zero-hour contract workers.
Why is deflation undesirable?
Deflation is feared by economists because it leads to lower consumer spending, which is a key component of economic growth. Companies respond to lower pricing by decreasing production, which results in layoffs and compensation cuts.
Who gains from deflation?
Deflation will benefit consumers in the short run by lowering the pricing of products. This not only boosts customers’ spending power, but it also encourages them to save more. In the above link, you can learn about Inflation in the Economy- Types of Inflation, Inflation Remedies.
What are the advantages and disadvantages of deflation?
Over time, deflation raises the value of money. During a period of deflation, a country’s prices will have a persistent tendency to fall. Deflationary disadvantages
Who suffers from deflation?
Exacerbating deflation can send an economy into a deflationary spiral. This occurs when price reductions lead to reduced production levels, which in turn leads to lower wages, which in turn leads to lower demand from businesses and consumers, resulting in more price reductions. Education and healthcare are two areas of the economy that have historically been well-insulated from economic downturns, as their expenses and prices may actually rise while the overall level of pricing for most products and services falls.
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 beneficial to stocks?
The liquidity trap is an economic condition that can occur as a result of deflation. During deflation, the value of products and assets decreases, making cash and other liquid assets more attractive. As a result, deflation acts as a deterrent to investment and expenditure. In reality, during a period of severe deflation, a safe full of cash or a bank account is one of the best investments. As a result, the very nature of deflation discourages stock market investment, and decreasing demand for stocks can have a negative impact on stock value.
What happens to the housing market 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?
During a deflationary period, who suffers the most?
- Consumer spending is discouraged. When costs are falling, individuals are more likely to put off purchases since they will be cheaper later. It can deter buyers from purchasing luxury products or non-essential items, such as a flatscreen TV, because they could save money by waiting for a lower price. As a result, deflationary periods frequently result in decreased consumer spending and slower economic growth (this, in turn, creates more deflationary pressure in the economy). The Japanese experience of deflation in the 1990s and 2000s was marked by a drop in consumer expenditure (Japanese financial crisis).
- Increase the debt’s real value. The real worth of money and the real value of debt both rise as a result of deflation. Debtors find it more difficult to repay their debts as a result of deflation. As a result, consumers and businesses must devote a greater portion of their discretionary income to debt repayment. (In a deflationary phase, corporations will receive lesser revenue, and consumers will likely receive lower pay.) As a result, there is less money available for spending and investment. This is especially problematic during a balance sheet recession, when businesses and people are attempting to minimize their debt exposure. Europe has a large amount of government debt, and deflation will make lowering debt-to-GDP ratios more difficult.
- Real interest rates have risen. Interest rates are not allowed to fall below zero. If there is 2% deflation, we will have a real interest rate of +2%. Saving money, in other words, yields an acceptable return. As a result, deflation might lead to an unwelcome tightening of monetary policy. This is especially problematic for Eurozone countries who do not have access to alternative monetary strategies such as quantitative easing. Another issue that can contribute to lesser growth and increased unemployment is this.
- Unemployment based on real wages. ‘Sticky wages’ are common in labor markets. Workers, in particular, are resistant to nominal wage cuts (no one likes to see their salaries reduced, especially when they are accustomed to annual raises). As a result, real wages grow during deflationary periods. This could result in real-wage joblessness. Low inflation is one of the reasons for Europe’s high unemployment rate.