What Does It Mean When Inflation Decreases?

Readers’ Question: Consider the implications of a lower inflation rate for the UK economy’s performance.

As the country’s goods become more internationally competitive, exports and growth increase.
Improved confidence, which encourages businesses to invest and boosts long-term growth.

However, if the drop in inflation is due to weak demand, it could lead to deflationary pressures, making it difficult to stimulate economic development. It’s important remembering that governments normally aim for a 2% inflation rate. If inflation lowers from 10% to 2%, it will have a positive impact on the economy. If inflation falls from 3% to 0%, it may suggest that the economy is in decline.

Benefits of a falling inflation rate

The rate of inflation dropped in the late 1990s and early 2000s. This signifies that the price of goods in the United Kingdom was rising at a slower pace.

Increased ability to compete Because UK goods will increase at a slower rate, reducing inflation can help UK goods become more competitive. If goods become more competitive, the trade balance will improve, and economic growth will increase.
However, relative inflation rates play a role. If inflation falls in the United States and Europe, the United Kingdom will not gain a competitive advantage because prices would not be lower.
Encourage others to invest. Low inflation is preferred by businesses. It is easier to forecast future costs, prices, and wages when inflation is low. Low inflation encourages them to take on more risky investments, which can lead to stronger long-term growth. Low long-term inflation rates are associated with higher economic success.
However, if inflation declines as a result of weak demand (like it did in 2009 or 2015), this may not be conducive to investment. This is because low demand makes investment unattractive low inflation alone isn’t enough to spur investment; enterprises must anticipate rising demand.
Savers will get a better return. If interest rates remain constant, a lower rate of inflation will result in a higher real rate of return for savers. For example, from 2009 to 2017, interest rates remained unchanged at 0.5 percent. With inflation of 5% in 2012, many people suffered a significant drop in the value of their assets. When inflation falls, the value of money depreciates more slowly.
The Central Bank may cut interest rates in response to a lower rate of inflation. Interest rates were 15% in 1992, for example, which meant that savers were doing quite well. Interest rates were drastically decreased when inflation declined in 1993, therefore savers were not better off.
Reduced menu prices Prices will fluctuate less frequently if inflation is smaller. Firms can save time and money by revising prices less frequently.
This is less expensive than it used to be because to modern technologies. With such high rates of inflation, menu expenses become more of a problem.
The value of debt payments has increased. People used to take out loans/mortgages with the expectation that inflation would diminish the real worth of the debt payments. Real interest rates may be higher than expected if inflation falls to a very low level. This adds to the real debt burden, potentially slowing economic growth.
This was a concern in Europe between 2012 and 2015, when very low inflation rates generated problems similar to deflation.
Wages that are realistic. Nominal salary growth was quite modest from 2009 to 2017. Nominal wages have been increasing at a rate of 2% to 3% each year. The labor market is in shambles. Workers witnessed a drop in real wages during this time, when inflation reached 5%. As a result, a decrease in inflation reverses this trend, allowing real earnings to rise.
Falling real earnings are not frequent in the postwar period, so this was a unique phase. In most cases, a lower inflation rate isn’t required to raise real earnings.

More evaluation

For example, in 1980/81, the UK’s inflation rate dropped dramatically. However, this resulted in a severe economic slowdown, with GDP plummeting and unemployment soaring. As a result, decreased inflation may come at the expense of more unemployment. See also the recession of 1980.

Monetarist economists, on the other hand, will argue that the short-term cost of unemployment and recession was a “price worth paying” in exchange for lowering inflation and removing it from the system. The recession was unavoidable, but with low inflation, the economy has a better chance of growing in the future.

Decreased inflation as a result of lower production costs (e.g., cheaper oil prices) is usually quite advantageous we get lower prices as well as higher GDP. Because travel is less expensive, consumers have more disposable income.

What is the ideal inflation rate? – why central banks aim for 2% growth, and why some economists believe it should be boosted to 4% in some cases.

What happens if the rate of inflation falls?

Low inflation typically indicates that demand for products and services is lower than it should be, slowing economic growth and lowering salaries. Low demand might even trigger a recession, resulting in higher unemployment, as we witnessed during the Great Recession a decade ago.

Deflation, or price declines, is extremely harmful. Consumers will put off buying while prices are falling. Why buy a new washing machine today if you could save money by waiting a few months?

Deflation also discourages lending because lower interest rates are associated with it. Lenders are unlikely to lend money at rates that provide them with a low return.

The Facts:

The inflation rate in the United States, as defined by the annual rate of change in prices of Personal Consumption Expenditures, peaked at over 10% in 1974, then again in 1980, before declining during the early 1980s recession and remaining low since (see chart). Since the start of 2009, when the Great Recession began in 2008, headline inflation has averaged 1.5 percent, while core inflation, which excludes food and energy prices and is thus less volatile, has averaged 1.3 percent. The Federal Reserve’s so-called Quantitative Easing strategy, which expanded the money supply by purchasing assets other than those generally included in open-market purchases, had a role in the recovery from the Great Recession. There were forecasts that this would result in substantial inflation, yet almost a decade later, there is still no indication of inflation or inflationary pressures.
Because low inflation is often associated with economic weakness, it can be an indication of trouble. People and businesses may be less eager to invest and spend on consumption when unemployment is high or consumer confidence is low, and this decreased demand prevents them from bidding up prices. When the economy softens, inflation tends to fall. For example, the rapid drop in inflation in the early 1980s occurred when the Federal Reserve raised interest rates, causing a sharp downturn in economic activity and raising the unemployment rate, which eventually reached 10.8% in November and December 1982. In October 2009, the unemployment rate reached 10%, however this was despite, rather than because, of the Federal Reserve’s attempts to help the economy recover during the Great Recession, which included low-interest rate policies. During the Great Recession, inflation was low; from March to September 2009, headline inflation was negative, while core inflation stayed around 1%.
The Federal Reserve has set a 2% inflation objective for the long term “in the medium term” in January 2012, a policy that is still in effect today. This is a symmetric objective, not a ceiling; in other words, Federal Reserve policy aims to keep inflation around 2%, while it may be higher or lower at times. However, since that policy was implemented, inflation has been almost constantly below 2%, with the most recent headline inflation figure of 1.4 percent in June 2017. This has cast doubt on the Federal Reserve’s decision to boost its key interest rate for the third time this year. The ongoing recovery from the Great Recession is the third-longest on record, and the current low unemployment rate would normally compel the Federal Reserve to set its policy path to prevent the economy from overheating, prompting calls for the Fed to raise interest rates. Even with unemployment rates of 4.3 percent in June and July, the lowest string of two-month jobless rates in more than 15 years, this recovery has not been followed by rising inflation.
Low inflation, on the other hand, raises the possibility of monetary policy being limited. The so-called zero-lower bound states that interest rates cannot fall below zero (or at least not by much). Interest rates fall as predicted inflation falls, because a lender’s interest rate is partly a hedge against being repaid in dollars whose value has been reduced by inflation (this is called the Fisher Effect after the early 20th century Yale economist Irving Fisher). When the economy is sluggish, low interest rates and the zero lower bound limit the Federal Reserve’s ability to decrease rates further. The present interest rate on one-year Treasury Bills is 1.2 percent, and the Federal Reserve may not be able to maintain this rate “keep its ammunition dry” in the event that the economy deteriorates.
Another issue with low inflation is the impact it could have on the financial system’s operation. Banks earn on the difference between their borrowing costs and their lending income. With the lower interest rates that come with lower inflation, this spread tends to narrow. While financial sector profitability is not a policy goal in and of itself, it is vital for the financial sector to function and, as a result, for the health of the economy. Banks and other financial institutions, on the other hand, profit from a variety of sources, including fees and asset holdings. Indeed, with the Federal Reserve deeming major banks healthy in June 2017 and robust bank profitability, bank stockholders are expected to enjoy their largest dividends in a decade.
In the extreme, when an economy’s inflation rate falls below zero, it raises extra issues and the possibility of deflation. Prices and incomes are declining in a deflationary environment. However, the face value of existing debt will not decrease, nor will planned interest payments, and deflation will raise the cost of fixed interest payments on the debt in terms of prices and wages. This can result in a debt-deflation cycle, which Irving Fisher proposed in 1933 as one explanation for the Great Depression of the 1930s. In a debt-deflation cycle, the increased cost of servicing the debt, expressed in prices and wages, reduces demand in the economy, contributing to additional deflation, and so on.

Low inflation favours whom?

Almost every economist recommends keeping inflation low. Low inflation promotes economic stability, which fosters saving, investment, and economic growth while also assisting in the preservation of international competitiveness.

Governments normally aim for a rate of inflation of around 2%. This moderate but low rate of inflation is thought to be the optimal compromise between avoiding inflation costs while also avoiding deflationary costs (when prices fall)

Benefits of low inflation

To begin with, if inflation is low and stable, businesses will be more confident and hopeful about investing, resulting in increased productive capacity and future greater rates of economic growth.

There could be an economic boom if inflation is allowed to rise due to permissive monetary policy, but if this economic growth is above the long run average rate of growth, it is likely to be unsustainable, and the bubble will be followed by a crash (recession)

After the Lawson boom of the late 1980s, this happened in the UK in 1991. As a result, keeping inflation low will assist the economy avoid cyclical oscillations, which can lead to negative growth and unemployment.

If UK inflation is higher than elsewhere, UK goods will become uncompetitive, resulting in a drop in exports and possibly a worsening of the current account of the balance of payments. Low inflation and low production costs allow a country to remain competitive over time, enhancing exports and competitiveness.

Inflationary expenses include menu costs, which are the costs of updating price lists. When inflation is low, the costs of updating price lists and searching around for the best deals are reduced.

How to achieve low inflation

Policy monetary. The Central Bank can boost interest rates if inflation exceeds its target. Higher interest rates increase borrowing costs, restrict lending, and lower consumer expenditure. This decreases inflationary pressure while also moderating economic growth.
Control the supply of money. Monetarists emphasize regulating the money supply because they believe there is a clear link between money supply increase and inflation. See also: Why does an increase in the money supply produce inflation?
Budgetary policy. If inflation is high, the government can use tight fiscal policy to minimize inflationary pressures (e.g. higher income tax will reduce consumer spending). Inflation is rarely controlled through fiscal policy.
Productivity growth/supply-side policies Supply-side strategies can lessen some inflationary pressures in the long run. For example, powerful labor unions were criticised in the 1970s for being able to raise salaries, resulting in wage pull inflation. Wage growth has been lower and inflation has been lower as a result of weaker unions.
Commodity prices are low. Some inflationary forces are beyond the Central Bank’s or government’s control. Cost-push inflation is virtually always a result of rising oil costs, and it’s a difficult problem to tackle.

Problems of achieving low inflation

If a central bank raises interest rates to combat inflation, aggregate demand will decline, economic growth would slow, and a recession and more unemployment may occur.

The Conservative administration, for example, hiked interest rates and adopted a tight budgetary policy in the early 1980s. This cut inflation, but it also contributed to the devastating recession of 1981, which resulted in 3 million people losing their jobs.

Monetarists, on the other hand, believe that inflation may be minimized without compromising other macroeconomic goals. This is because they believe that the Long Run Aggregate Supply is inelastic, and that any decrease in AD will only result in a brief drop in Real GDP, with the economy returning to full employment within a short period.

Can inflation be too low?

Since the financial crisis of 2008, global inflation rates have been low, but some economists claim that this has resulted in sluggish economic growth in the Eurozone and elsewhere.

Japan’s experience in the 1990s demonstrated that extremely low inflation can lead to a slew of significant economic issues. Inflation was quite low in the 1990s and 2000s, but Japan’s GDP was well below its long-term norm, and unemployment was rising. Rising unemployment has a number of negative consequences, including rising inequality, more government borrowing, and an increase in social problems. Even if it conflicts with increased inflation, economic expansion is perhaps a more significant goal in this scenario.

Economists have expressed concerned about the Eurozone’s exceptionally low inflation rates from 2010 to 2017. Deflation has occurred in countries such as Greece and Spain, but unemployment rates have risen to over 25%.

Low inflation usually provides a number of advantages that assist the economy perform better, such as greater investment.

In other cases, though, keeping inflation low may be detrimental to the economy. Maintaining the inflation target in the face of a supply-side shock to the economy could result in higher unemployment and slower development, both of which are undesirable outcomes. As a result, the government should aim for low inflation while being flexible if this looks to be unsuited in the current economic context.

Why is it vital to lower inflation?

A low rate of inflation encourages the most effective use of economic resources. When inflation is strong, a significant amount of time and resources from the economy are spent by individuals looking for ways to protect themselves from inflation.

What impact does low inflation have on businesses?

Inflation decreases money’s buying power by requiring more money to purchase the same products. People will be worse off if income does not increase at the same rate as inflation. This results in lower consumer spending and decreased sales for businesses.

What is creating 2021 inflation?

As fractured supply chains combined with increased consumer demand for secondhand vehicles and construction materials, 2021 saw the fastest annual price rise since the early 1980s.

What happens if inflation becomes too high?

If inflation continues to rise over an extended period of time, economists refer to this as hyperinflation. Expectations that prices will continue to rise fuel inflation, which lowers the real worth of each dollar in your wallet.

Spiraling prices can lead to a currency’s value collapsing in the most extreme instances imagine Zimbabwe in the late 2000s. People will want to spend any money they have as soon as possible, fearing that prices may rise, even if only temporarily.

Although the United States is far from this situation, central banks such as the Federal Reserve want to prevent it at all costs, so they normally intervene to attempt to curb inflation before it spirals out of control.

The issue is that the primary means of doing so is by rising interest rates, which slows the economy. If the Fed is compelled to raise interest rates too quickly, it might trigger a recession and increase unemployment, as happened in the United States in the early 1980s, when inflation was at its peak. Then-Fed head Paul Volcker was successful in bringing inflation down from a high of over 14% in 1980, but at the expense of double-digit unemployment rates.

Americans aren’t experiencing inflation anywhere near that level yet, but Jerome Powell, the Fed’s current chairman, is almost likely thinking about how to keep the country from getting there.

The Conversation has given permission to reprint this article under a Creative Commons license. Read the full article here.

Photo credit for the banner image:

Prices for used cars and trucks are up 31% year over year. David Zalubowski/AP Photo

Is inflation beneficial to stocks?

Consumers, stocks, and the economy may all suffer as a result of rising inflation. When inflation is high, value stocks perform better, and when inflation is low, growth stocks perform better. When inflation is high, stocks become more volatile.

Governments seek inflation for what reason?

Question from a reader: Why does inflation make it easier for governments to repay their debts?

During the 1950s, 1960s, and 1970s, when inflation was quite high, the national debt as a percentage of GDP dropped dramatically. Deflation and massive debt characterized the 1920s and 1930s.

Inflation makes it easier for a government to pay its debt for a variety of reasons, especially when inflation is larger than planned. In conclusion:

Nominal tax collections rise as inflation rises (if prices are higher, the government will collect more VAT, workers pay more income tax)
Higher inflation lowers the actual worth of debt; bondholders with fixed interest rates will see their bonds’ real value diminish, making it easier for the government to repay them.
Higher inflation allows the government to lock income tax levels, allowing more workers to pay higher tax rates thereby increasing tax revenue without raising rates.

Why inflation can benefit the government at the expense of bondholders

Let’s pretend that an economy has 0% inflation and that people anticipate it to stay that way.
Let’s say the government needs to borrow 2 billion and sells 1,000 30-year bonds to the private sector. The government may give a 2% annual interest rate to entice individuals to acquire bonds.
The government will thereafter be required to repay the full amount of the bonds (1,000) as well as the annual interest payments (20 per year at 2%).
Investors who purchase the bonds will profit. The bond yield (2%) is higher than the inflation rate. They get their bonds back, plus interest.
Assume, however, that inflation of 10% occurred unexpectedly. Money loses its worth as a result of this. As prices rise as a result of inflation, 1,000 will buy fewer products and services.
As salaries and prices rise, the government will receive more tax money as a result of inflation (for example, if prices rise 10%, the government’s VAT receipts will rise 10%).
As a result, inflation aids the government in collecting more tax income.
Bondholders, on the other hand, lose out. The government still owes only 1,000 in repayment. However, inflation has lowered the value of that 1,000 bond (it now has a real value of 900). Because the inflation rate (ten percent) is higher than the bond’s interest rate (two percent), their funds are losing actual value.
Because of inflation, repaying bondholders needs a lesser percentage of the government’s overall tax collection, making it easier for the government to repay the original loan.

As a result of inflation, the government (borrower) is better off, whereas bondholders (savers) are worse off.

Evaluation (index-linked bonds)

Some bondholders will purchase index-linked bonds as a result of this risk. This means that if inflation rises, the maturity value and interest rate on the bond will rise in lockstep with inflation, protecting the bond’s real value. The government does not benefit from inflation in this instance since it pays greater interest payments and is unable to discount the debt through inflation.

Inflation and benefits

Inflation is expected to peak at 6.2 percent in 2022 in the United Kingdom, resulting in a significant increase in nominal tax receipts. The government, on the other hand, has expanded benefits and public sector salaries at a lower inflation rate. In April 2022, inflation-linked benefits and tax credits will increase by 3.1%, as determined by the Consumer Price Index (CPI) inflation rate in September 2021.

As a result, public employees and benefit recipients will suffer a genuine drop in income their benefits will increase by 3.1 percent, but inflation might reach 6.2 percent. The government’s financial condition will improve in this case by increasing benefits at a slower rate than inflation.

Only by making the purposeful decision to raise benefits and wages at a slower rate than inflation can debt be reduced.

Inflation and bracket creep

Another approach for the government to benefit from inflation is to maintain a constant income tax level. The basic rate of income tax (20%), for example, begins at 12,501. At 50,000, the tax rate is 40%, and at 150,000, the tax rate is 50%. As a result of inflation, nominal earnings will rise, and more workers will begin to pay higher rates of income tax. As a result, even though the tax rate appears to be unchanged, the government has effectively raised average tax rates.

Long Term Implications of inflation on bonds

People will be hesitant to buy bonds if they expect low inflation and subsequently lose the real worth of their savings due to high inflation. They know that inflation might lower the value of bondholders’ money.

If bondholders are concerned that the government will generate inflation, greater bond rates will be desired to compensate for the risk of losing money due to inflation. As a result, the likelihood of high inflation may make borrowing more onerous for the government.

Bondholders may not expect zero inflation; yet, bondholders are harmed by unexpected inflation.

Example Post War Britain

Inflation was fairly low throughout the 1930s. This is one of the reasons why individuals were willing to pay low interest rates for UK government bonds (in the 1950s, the national debt increased to over 230 percent of GDP). Inflationary effects lowered the debt burden in the postwar period, making it simpler for the government to satisfy its repayment obligations.

In the 1970s, unexpected inflation (due to an oil price shock) aided in the reduction of government debt burdens in a number of countries, including the United States.

Inflation helped to expedite the decline of UK national debt as a percentage of GDP in the postwar period, lowering the real burden of debt. However, debt declined as a result of a sustained period of economic development and increased tax collections.

Economic Growth and Government Debt

Another concern is that if the government reflates the economy (for example, by pursuing quantitative easing), it may increase both economic activity and inflation. A higher GDP is a crucial component in the government’s ability to raise more tax money to pay off its debt.

Bondholders may be concerned about an economy that is expected to experience deflation and negative growth. Although deflation might increase the real value of bonds, they may be concerned that the economy is stagnating too much and that the government would struggle to satisfy its debt obligations.