You are more at risk from deflation than from inflation. When asset and consumer costs fall over time, this is referred to as deflation. While this may appear to be good news for shoppers, widespread deflation results from a long-term drop in demand. Deflation often heralds the start of a recession. A recession brings lower wages, job losses, and significant losses to most investment portfolios. Deflation increases as a recession worsen. Businesses slash prices in an attempt to persuade customers to buy their goods and services.
Important Points to Remember
- When the costs of goods and services fall, this is referred to as deflation.
- Consumers anticipate lower prices in the future as a result of deflation expectations. As a result, demand falls, and growth slows.
- Interest rates can only be brought to zero, so deflation is worse than inflation.
- Good deflation can be achieved through innovation.
- Counting the Losses
Causes
Since 2000, there are three reasons why deflation has been a greater threat than inflation. To begin with, Chinese exports have kept prices low. Because the country's standard of living is lower, its workers are paid less. China also keeps its currency pegged to the dollar, allowing its exports to remain competitive. Second, in the twenty-first century, technology such as computers ensures that workers remain productive. The majority of information can be found on the internet in a matter of seconds. Workers don't have to waste time looking for it. Business communications were streamlined when they switched from snail mail to email. Third, the many retiring baby boomers allow businesses to keep wages low. Because they can't afford to retire, many baby boomers have stayed in the workforce. To supplement their incomes, they are willing to accept lower wages. Because of the lower costs, companies haven't had to raise their prices.The Warning Tale of Deflation
Economic growth is slowed by deflation. People are deferring purchases as prices fall. They are hoping for a better deal later. You've probably had this experience when considering a new cell phone, iPad, or television. You could save money by waiting until next year to get this year's model. Manufacturers are under constant pressure to lower prices and develop new products due to this. That's great for consumers like you, but it means lower wages and less investment spending. As a result, only companies with a fervent, devoted following, such as Apple, can truly succeed in this market. Note: Massive deflation aided the Great Depression's transformation into the 1929 recession. Demand for goods and services fell as unemployment rose. According to the Bureau of Labor Statistics, the Consumer Price Index fell 27% from November 1929 to March 1933. Companies went out of business as prices dropped. More people lost their jobs. World trade had essentially collapsed by the time the dust settled. From $3 billion in 1929 to $992 million in 1933, the volume of goods and services traded fell by 67 percent.How Is It Being Stopped?
The Federal Reserve uses expansionary monetary policy to combat deflation to boost the economy. It lowers the fed funds rate target and uses open market operations to buy Treasurys. When necessary, the Fed employs other methods to boost the money supply. People often wonder if the Fed is printing money when it increases economic liquidity. Our elected officials can also use discretionary fiscal policy, such as tax cuts to counteract falling prices. They have the ability to increase government spending as well. Both result in a short-term deficit. Discretionary fiscal policy, on the other hand, becomes less popular when the deficit is already at record levels. Important: Why does monetary or fiscal expansion work to prevent deflation? It stimulates demand if done correctly. People are more likely to buy what they want and what they need if they have more money to spend. They will no longer wait for prices to drop further. This increase in demand will cause prices to rise, reversing the deflation trend.Deflation Is Worse Than Inflation For These Reasons
Inflation is the polar opposite of deflation. When prices rise over time, this is referred to as inflation. Because people's expectations worsen price trends, both economic responses are difficult to combat once established. When prices rise due to inflation, an asset bubble forms, and central banks can pop this bubble by raising interest rates. In the 1980s, former Fed Chairman Paul Volcker demonstrated this. By raising the Fed funds rate to 20%, he was able to combat double-digit inflation. Even though it caused a recession, he kept it. He needed to take such drastic measures to persuade everyone that inflation could be controlled. Central bankers now know that controlling people's expectations of price changes is the most important tool in combating inflation or deflation, thanks to Volcker. Important: Deflation is worse than inflation because interest rates can only be lowered to zero. Central banks will need to use other tools once rates have reached zero, but as long as businesses and people feel less wealthy, they will spend less, reducing demand. They don't mind if interest rates are zero because they don't need to borrow in the first place. There is excess liquidity, but it serves no purpose. It's similar to pulling a string. The deadly situation is known as a liquidity trap, and a vicious downward spiral characterizes it.There Are Only a Few Times When Deflation Is Beneficial
While a large, widespread drop in prices is always bad for the economy, deflation in some asset classes can be beneficial. Consumer goods, particularly computers and electronic equipment, have been deflationary for some time. It is due to innovation rather than a drop in demand. Production of consumer goods has shifted to China, where wages are lower. This is a manufacturing breakthrough that lowers the cost of many consumer goods. In the case of computers, manufacturers look for ways to reduce the size and power of the components while maintaining the same price. This is a case of technological advancement. It maintains the competitiveness of computer manufacturers.Japan as a Modern Case Study
For the past 30 years, Japan's economy has been in a deflationary spiral. It all started when Japan's housing bubble burst in the late 1980s. People in Japan began to save money. When they noticed signs of a recession, they cut back on spending and put money aside for a rainy day. They reasoned that saving is better since wages and prices are unlikely to rise. Instead of investing the extra funds in new business ventures, banks put them into government debt. Four other factors, according to a Stanford University study led by Daniel Okimoto, are contributing to the long-running downward spiral:- The ruling political party failed to take the difficult steps to boost the economy.
- In 1997, taxes were increased.
- Banks kept bad loans on their books for a long time. This practice constrained the capital available for expansion.
Most Commonly Asked Questions (FAQs)
What are the ways to profit from deflation?
Because deflation is more common during recessions, profiting from deflationary environments is similar to profiting from other recessions. Fixed-income investments, for example, provide guaranteed income streams regardless of market conditions, as long as the issuer does not default.What happens to house prices in a deflationary environment?
During deflationary periods, the prices of most assets, including houses, fall. For example, between 1929 and 1933, the median price of a home fell by 22%.