- Although a reduction in the supply of money and credit is usually connected with deflation, prices can also decline as a result of greater productivity and technical advancement.
- Deflation encourages people to save money because a dollar can purchase more in the future than it does now, creating negative feedback loops that can lead to economic misery.
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.
What are the consequences of low or negative inflation?
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.
Is negative inflation beneficial?
1 When the index is lower in one period than in the preceding period, the overall level of prices has fallen, indicating that the economy is in deflation. This general price decrease is beneficial since it offers customers more purchasing power.
Why is deflation harmful to the economy?
Deflation is usually an indication of a deteriorating economy. 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.
Which is more dangerous: inflation or deflation?
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.
What exactly is the issue with modest inflation?
According to some economists, what is the major issue with modest inflation? To protect against inflation, it diverts valuable time to activities. Inflationary cost-push. Lenders suffer, while borrowers gain.
Why is low inflation preferable than none?
Low inflation is preferable because an economy with no growth in inflation (or zero inflation) risks deflation. Reduced pricing equals less production and lower pay, which pushes prices to fall even more, resulting in even lower wages, and so on.
Why is inflation such a challenging issue in so many countries?
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.
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Photo credit for the banner image:
Prices for used cars and trucks are up 31% year over year. David Zalubowski/AP Photo
What consequences does deflation have?
- 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.
Is deflation ever experienced?
Deflation is defined as a drop in the overall cost of goods and services in an economy. While a little price fall may encourage consumer spending, widespread deflation can discourage expenditure, leading to even more deflation and economic downturns.
Fortunately, deflation is rare, and when it does, governments and central banks have instruments to mitigate its effects.