Inflation, as we all know, is the sustained rise in prices of everyday goods and services, best experienced while tanking up at the petrol pump or buying your monthly grocery. Conversely, deflation is the decrease in the general price level, which should normally be a cause for celebration. But it is not, as we will find out in a bit.
To elaborate, people have less money in their hands to purchase stuff due to decreased money supply in the economy. And this leads to a reduction in demand and hence prices. That is deflation in pure economic terms. Let us break down the concept further with the help of an analogy.
Famous actor Denzel Washington once said: “You pray for the rain, you gotta deal with the mud too.” In the context of finance, consider rain as “inflation” and mud as “deflation.” We will keep building on this relatable example as we go along.
Understanding deflation and its downside
Consider this: the prices of goods and services increase due to higher demand. People have a lot of money in their hands (the rain they asked for), driving up the demand and higher prices. This is what we call inflation. Some inflation is good for the economy, but when the prices inflate beyond a point, the government intervenes— hiking interest rates as a strategy. (Remember Jerome Powell).
Successive rate hikes and a prolonged phase of central bank intervention can reduce inflation, often substantially. And if the inflation rate keeps going down—even below the 0% mark—technically, we enter a deflationary phase. And unlike inflation, where the services and goods become costlier, deflation makes everything cheaper.
Inflation is bad enough, as you would agree hands down. Therefore, declining prices should be good news for consumers as they should be able to buy more with less. Well, not exactly. When prices keep going down, people defer purchases in the hope of striking better deals in the near future. This deferred buying behavior, in turn, is bad for producers who may cut production, eventually leading to unemployment and further price reduction. All of that might lead to a financial depression or recession.
Hence, if you look at the bigger picture, deflation is a big red alert for any economy. It is the mud that follows the rain called inflation.
Causes for deflation
If you have read our detailed piece on inflation, you would know that increase in demand (demand-pull) or an increase in production cost (cost-push) can lead to a rise in overall prices. Deflation is a mirror image of inflation, caused by a decrease in overall demand.
However, here are the specific reasons leading to a decrease in demand:
1. Declining confidence: Unfavorable economic scenarios usually lead to reduced demand. The pandemic remains fresh in our memory, where the lockdowns, lay-offs, and the like led to a decline in demand. This, in turn, hurt producers and manufacturers, who had cut to cut jobs, pushing the demand down further.
2. Monetary policy: This is where the government intervenes with its monetary policy tools. Generally, central banks hike interest rates to rein in inflation. However, as the interest rates go up, the spending habits of people take a hit, which in turn lowers overall demand.
3. Ripple effect: Even as the demand goes down, aggregate supply increases. To sell off the surplus, manufacturers lower the prices to stay above the competition, leading to deflation. Technological advancements, capable of speeding up production, can also cause deflation.
Effects of deflation
Prima facie, the effects of deflation might sound positive.
Inflation increases consumer prices, which means one unit of money can buy fewer products. In other words, the currency weakens. During deflation, one unit of money can buy a lot more— strengthening the currency in the process.
However, as the currency keeps getting stronger, production costs keep going down, making it easier for manufacturers to produce more. This, in turn, amplifies the overall supply.
Net result: lowering demand and growing supply.
However, the so-called positive effects are transitory, as we can see.
Expensive debt: As interest rates increase, consumer and business debt soar. Increasing mortgage and credit card payments would pinch, making people spend less and slowing economic growth.
Growing unemployment: Companies need to offer discounts to sell off their products and services. As a result, the firms become less profitable, and they end up cutting workforce strength.
One can infer that the nominal rates—the rate advertised by banks—associated with labor, capital, and services go down during deflation, while relative rates remain constant. Relative rates are the rates in relation to the strengthening currency. Consider this: during deflation, home renovation (a service) becomes 10% cheaper, on paper. However, the relative rate didn’t change as the currency strengthened during this time—allowing users to afford the same service for fewer bucks.
In some cases, governments resort to money printing to combat deflation— especially to increase the supply of money and the demand for products and services.
How to measure and analyze deflation?
Consumer Price Index (CPI) is a reliable economic indicator that helps you measure inflation and deflation. For instance, the US CPI is currently at 8.3%, way above the target of 2%. The reading indicates that the economy is battling inflation at the moment. However, if the figure drops below 2%, there is a fair chance of the economy slipping into a deflationary stage.
What happens during deflation?
On the face of it, consumers benefit from deflation as prices go down. Yet, economists consider this a harbinger of economic depression as the supply-demand curve needs to stay balanced and not be stacked in favor of either component.
If you analyze closely, deflation harms borrowers as the borrowed money they have to pay interest against is now higher than before. For comparison, inflation reduces the value of outstanding debt.
How do you make money during deflation?
Yes, deflation has adverse effects. Yet, if you plan right, making money during deflation is still possible. Some of the most effective strategies include:
Sell the right product to make sure you only cater to the existing demand.
Manage business contracts better and try to land bulk orders, focusing more on sales volumes.
If you are a business trying to cut costs, reducing salaries can be a better bet than laying off employees.
Deflation could harm you more
And that’s pretty much everything you need to know about deflation. More importantly, deflation tends to unleash more harm than inflation. Deflation reduces prices but also inflicts some damage on the economy.
On a positive note, prudent investment decisions can help you beat inflation. However, there is no surefire approach to protect yourself from deflation as its effects are more far-reaching, including a possible downward spiral into depression.
FAQs
Why is deflation a problem?
Deflation, a widespread and sustained decrease in prices, can hinder economic growth. It discourages spending as people delay purchases in anticipation of lower prices, leading to reduced demand, lower production, job cuts, and economic stagnation.
What is deflation in simple words?
Deflation means prices for things you buy decrease over time. While it might sound good, it can lead to problems like people waiting to buy, hurting businesses and jobs.
Why is deflation worse than inflation?
Deflation is worse than inflation because it can lead to economic stagnation. When prices fall, people delay spending, businesses suffer, and jobs are lost. It’s a cycle that’s harder to break compared to controlled inflation.
Which is better deflation or inflation?
Moderate inflation is generally considered better than deflation. Inflation encourages spending, investment, and economic growth. Deflation can lead to economic slowdown, job losses, and stagnant markets. Balancing both is ideal for a healthy economy.
