Why is deflation bad?

Interest rates are at historically low levels, and central banks remain fixated on quantitative easing some eight years after the economic crisis.  What lies behind this reluctance to return western economies to “normal” monetary conditions?  The answer lies in the fear of deflation.

For most of my adult life, central bankers have been concerned about controlling inflation, raising interest rates when animal spirits became excessive, so as to choke off the damaging pressure of rising prices for those on fixed incomes.  But ever since the 2007/08 financial crisis, economies in the west have seen little if any wage growth and anaemic, if not negative, price increases.  As a result, the focus has been on keeping economies stimulated to keep the plates spinning.  What is it that they fear?  Why is deflation bad?

Deflation (a sustained period of falling prices) is feared by central bankers because it has the capacity to sink an economy.  The argument is that if consumers expect prices to be lower tomorrow, they will delay purchasing decisions today, particularly if big-ticket items such as cars and houses are concerned.  Once deflationary expectations take hold, overall demand falls and so companies have to reduce the prices of their goods and services to attract the slumping demand.  As a result, deflation becomes more acute, and so the spiral continues downward.

Another reason deflation reduces demand within an economy is because of its effect on borrowers.  When we think of our parents, who bought houses decades ago using mortgage loans, we see how inflation has worked to their advantage.  During that time, property prices have risen along with nominal wages, and what at first seemed like huge debts are now much more comfortable, having been eroded by inflation.  Now turn that on its head and imagine that house prices and wages had fallen over the last twenty or thirty years.  Suddenly, those mortgage loans would appear insurmountable as they would have risen in real terms, appearing much larger today than when they were taken out.  When borrowers fear debt burdens rising in real terms, their confidence falls, so they cut back on spending, thus driving down demand and further fuelling deflation.

Many of our decisions as consumers are based on confidence in the future.  If we expect our incomes to rise over time and if we anticipate houses to go up in value, we will be comfortable spending and borrowing today.  Most economies work on this upwards and onwards principle, which is why central bankers target to achieve modest levels of inflation and fear stepping too near the deflationary cliff edge.

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