Definition: Deflation is when asset and consumer prices fall over time. This may seem like a great thing for shoppers, except that the cause of widespread deflation is a long-term drop in demand. It means that a recession is probably underway. That brings job losses, declining wages and a big hit to your stock portfolio. As a recession worsens, so does deflation. Businesses lower prices in a desperate attempt to get people to buy their products.
Officially, 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, and businesses use them to fund growth. That means when the stock market drops, the CPI might be missing one important indicator of deflation as it s felt in people s pocketbooks. For more, see How a Stock Market Crash Can Cause a Recession.
The CPI does not 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 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.
That means the CPI can give a false low reading when home prices are high and rents are low.
This is why it did not warn of asset inflation during the housing bubble of 2006. If it had, the Federal Reserve could have raised interest rates to prevent the bubble. That would have also prevented the pain when the bubble burst in 2007.
There are three reasons why deflation has been a greater threat than inflation since 2000.
First, exports from China have kept prices low. It has a lower standard of living, so it can pay its workers less. China also keeps its exchange rate pegged to the dollar. That keeps its exports competitive.
Second, in the 21st century, technology such as computers keeps workers productivity high. Most information can be gotten 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 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 come up with 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.
Massive deflation helped turn the 1929 recession into the Great Depression. As unemployment rose, demand for goods and services fell. Prices dropped 10 percent a year. As prices fell, companies went out of business. More people became unemployed.
When the dust settled, world trade essentially collapsed. The volume of goods and services traded fell 25 percent. And thanks to lower prices, the value of this trade was down 65 percent as measured in dollars.
To combat deflation, the Fed stimulates the economy with expansionary monetary policy. It reduces the fed funds rate target. It also buys Treasurys using its open market operations.
In addition, our elected officials can offset falling prices with discretionary fiscal policy. That means 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.
The opposite of deflation is inflation. That s when prices rise over time. Both are very difficult to combat once entrenched. That s because peoples 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 percent. 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. After that, 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. It is a vicious, downward spiral.
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, adding more power for the same price. This is technological innovation, and it keeps computer manufacturers competitive.
Japan s economy has been caught in a deflationary spiral for the past 30 years. It started in 1989, when the Bank of Japan raised interest rates and caused the housing bubble to burst. During that decade, the economy grew less than 2 percent per year as businesses cut back on debt and spending. An excess of workers decreased productivity. (Japan s culture discourages employee layoffs.) The Japanese people are also savers. When they saw the signs of recession, they stopped spending and put away funds for bad times.