What is deflation?

Q&A: What is deflation?
Gary Duncan

What is deflation?

The dreaded “D” word, one of the most feared economic blights, refers to sustained falls in prices in the economy for goods and services.

Don't we already have falling prices for some products?

Yes. For goods such as many types of clothing, Britain has got used to steadily cheaper prices as a result of intense high street competition and cheap imports from Asia. But deflation is different, meaning falls in prices more or less across the board.

But that sounds good. What's the problem?

The trend can sound like a money-saving bonanza. A short-lived burst of deflation for only a few months might end up like that and need not be a disaster. Problems start when consumers collectively curb spending, constantly waiting for ever-cheaper prices. In turn, this sucks the lifeblood of demand from the economy. With spending falling sharply, businesses sell less and less and are forced to cut wages and lay off staff — leading to even less spending, lower demand and sharper falls in prices. A vicious, downward spiral takes hold that can spell deep and prolonged recession. Once deflation sets in, it can be tough to reverse it, as negative effects feed on themselves. For example, if interest rates have been cut sharply to try to rekindle spending, then once they fall to zero it is impossible to cut them further and, after factoring in falling prices, this means that real interest rates are still higher than zero.

Are there any other effects?

Unfortunately, yes. Debt is a headache. Where prices and incomes generally are falling in a bout of deflation, this means that the real value of people's debts, relative to falling incomes, is rising. So debts become an ever bigger burden, stretching the time that is needed to pay them off to longer periods. This is known as “debt deflation”. In an economy such as Britain's, where households have the highest burden of debt of any leading economy, it poses a particularly severe danger.

How can economies escape?

With great difficulty. Deflation is like quicksand. Once in it, it is very difficult to escape the mire. Solutions to “reflate” the economy are found in flooding the financial system with ultra-cheap money. This can be done by governments printing money to give away in tax cuts, although this risks irreversible damage to a country's finances, or by a central bank buying up assets from banks, effectively handing them extremely cheap cash.

Is deflation likely to take hold now?

There is a significant danger. Headline inflation in the United States could turn negative as soon as this week, after a huge reversal of last year's surge in fuel prices. In Britain, the Bank has said that it expects inflation on some measures to fall into negative territory for at least a few months. This may fall short of full-blown deflation, but will magnify the danger of it.

http://business.timesonline.co.uk/tol/business/economics/article5750994.ece