Most investors / readers know about inflation -- an increase in the price of a good or service not connected to an improvement. But fewer know about its flipside -- deflation -- a decline in prices.
Moreover, while inflation is a serious problem -- it erodes purchasing power and makes it hard for businesses to project and plan for costs, moving forward- - deflation is an even bigger menace.
That's because deflation decreases the amount of money flowing to businesses for their products/services, reducing the money needed to keep commercial activity alive and the economy growing.
Deflation: a danger sign
Don't misunderstand: a price cut after a company becomes more-efficient, or implements a 'holiday or promotional' sale, is fine. Deflation is different: it's pervasive price cutting and asset price declines -- falling prices across the product/service spectrum -- usually driven by a lack of consumer / wholesale demand.
Further, if deflation persists it can, you guessed it, lead to lay-offs. Companies and factories with lower revenue and demand for their products / services scale-back production to reduce expenses by laying-off employees. Those laid-off employees then cut expenses as they search for new work assignments by cutting spending, resulting in even lower demand for products, further price cuts, and lower company revenues, and a vicious cycle can ensue.
With the financial crisis that's squeezed credit in the U.S. now beginning to affect Europe, Bloomberg News reported Monday, are we approaching the danger of deflation? Economist David H. Wang says all of the symptoms are there. "We have falling commodity and raw materials prices, falling home prices, a pull-back in consumer spending, slowing GDP growth just about everywhere, and the worst credit conditions in several generations. These are all characteristic of a deflationary cycle," Wang said.
If commodity prices continue to decline and consumer prices do as well, "the Fed will have to cut rates, so will Europe and other central banks" to prevent the aforementioned deflation spiral, Wang said.
"n the fiscal side, increased government borrowing risks the danger of rising inflation. But that increase in spending has to be seen against a backdrop of a U.S. and now a global de-leveraging that's putting a downward pressure on prices," Wang said. "It's clear now the greater risk and danger is deflation, and that's what the Fed and other central banks should be fighting."
Monetary / Economic Analysis: What the U.S. -- and the world -- wants to avoid is a protracted period of declining prices. There always the risk that long-term inflation will rise, but policy makers must focus on preventing deflation, even it means higher inflation later, in order to prevent the serious damage that deflation would cause to the economy.
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Reader Comments (Page 1 of 1)
11-24-2008 @ 6:31AM
R. I. Burnham said...
During an inflationary period, the consumer's interest is to buy as soon as possible before the price of the wanted item increases. On the other hand, in a deflationary period, the opposite occurs. The consumer puts off the purchase in anticipation of a lower price in the future. That is the danger to the economy during a deflationary period. The pressure is to postpone spending. Why should I buy a car, a house or take a trip, etc. if I feel certain that the price will be lower tomorrow or the next day.