WHAT IS DEFLATION?

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Deflation is an economic term used to describe a period of declining prices for goods and services. Decreases in the money supply, government spending, consumer demand and business investment have all been cited as causes of deflation.

Deflation usually happens during an economic depression when there is lower demand for goods and services and higher levels of unemployment.  To counteract deflation in the United States economy, the Federal Reserve Bank (the Fed) uses its monetary policy powers to increase the money supply.  An increase in the money supply can stimulate spending.  The increased spending can cause price inflation as demand for goods and services increases.

The Fed is most noted for using its monetary powers to counter inflation.  However, it is equally wary of chronic, persistent deflation, such as Japan’s situation in the 1990s.  The Japanese banks lowered interest rates to zero to combat deflation.  It took until 2006, however, for this move to start restoring the Japanese economy.

Continued, rapid deflation can cause a circular domino effect of lower profits, bankrupt businesses, layoffs and high unemployment. Lower income would lead to lower demand for goods and services, meaning prices would drop — lowering profits still further — and the cycle would continue.  The Fed has been able to avoid this scenario through strategic implementation of monetary policy.

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Once deflation sets in, it can take decades for an economy to break out of its iron grip—Japan is still trying to climb out of a deflationary spiral dubbed the Lost Decades that began in 1990. But what can central banks do to fight the pernicious and devastating effects of deflation? In recent years, central banks around the world have pulled out all the stops, using extreme measures and innovative tools to combat deflation in their economies. Below, we will discuss how central banks fight deflation.

Effects of Deflation

Deflation is defined as a sustained and broad decline in price levels in an economy over a period of time. Deflation is the opposite of inflation and is also different from disinflation, which represents a period when the inflation rate is positive but falling.

Brief periods of lower prices, as in a disinflationary environment, are not bad for the economy. After all, who’s going to complain if one has to pay less for clothing, computers, cars, or childcare? Paying less for goods and services leaves consumers with more money left over for discretionary expenditures, which should boost the economy. In a period of declining inflation, the central bank is not likely to be especially “hawkish” (in other words, poised to aggressively raise interest rates) on monetary policy, which again would stimulate the economy.

But deflation is another story altogether. The biggest problem created by deflation is that it leads consumers to defer consumption, not with regard to the daily necessities of life like groceries, but for big-ticket items like appliances, cars, and houses. After all, the possibility that prices may go up is a huge motivator for buying big-ticket items (which is why sales and other temporary discounts are so effective).

In the United States, consumer spending accounts for 70 percent of the American economy and economists regard it as one of the most reliable engines of the global economy. Imagine the negative impact on the economy if these consumers begin to defer spending because they think goods may be cheaper next year.

Once consumer spending begins to decelerate, it has a ripple effect on the corporate sector, which begins deferring or slashing capital expenditures—spending on property, building, equipment, new projects, and investments. Corporations may also begin downsizing the workforce in order to maintain profitability. This creates a vicious circle, with corporate layoffs imperiling consumer spending, which in turn leads to more layoffs and rising unemployment. Such contraction in consumer and corporate spending can trigger a recession, and in the worst-case scenario, a full-blown depression.

Another hugely negative effect of deflation is its impact on debt burdens. While inflation chips away at the real (i.e., inflation-adjusted) value of debt, deflation has the opposite effect. It adds to the real debt burden. An increase in the debt burden at a time of recessionary conditions leads to increased debt defaults and bankruptcies by indebted households and companies.

Recent Deflation Concerns

Over the past quarter-century, concerns about deflation have spiked after big financial crises and/or the bursting of asset bubbles, such as the Asian crisis of 1997, the “tech wreck” of 2000-02, and the Great Recession of 2008-09. These concerns have assumed center stage in recent years because of Japan’s experience after its asset bubble burst in the early 1990s.

In order to counter the Japanese yen’s 50 percent rise in the 1980s and the resultant recession in 1986, Japan embarked on a program of monetary and fiscal stimulus. This had the effect of causing a massive asset bubble as Japanese stocks and urban land prices tripled in the second half of the 1980s. The bubble burst in 1990 as the Nikkei index lost a third of its value within a year, commencing a slide that lasted until October 2008 and took it down 80 percent from its December 1989 peak. As deflation became entrenched, the Japanese economy—which had been one of the fastest-growing in the world from the 1960s to the 1980s—slowed dramatically. Real GDP growth averaged only 1.1 percent annually from 1990 onward. In 2013, Japan’s nominal GDP was about 6 percent below its level in the mid-1990s. (For more on the Japanese economy, see From Mrs. Watanabe to Abenomics – the Yen’s wild ride).

The Great Recession of 2008-09 sparked fears of a similar period of prolonged deflation in the United States and elsewhere, because of the catastrophic collapse in prices of a wide range of assets—stocks, mortgage-backed securities, real estate, and commodities. The global financial system was also thrown into turmoil by the insolvency of a number of major banks and financial institutions in the United States and Europe, exemplified by the bankruptcy of Lehman Brothers in September 2008 (see Case Study – The Collapse of Lehman Brothers). There were widespread concerns that scores of banks and financial institutions that were on the verge of going under would do so in a domino effect, leading to a collapse of the financial system, a shattering of consumer confidence, and outright deflation.

How the Federal Reserve Fought Deflation

Fortunately, the Federal Reserve had the right man for the job in its Chairman Ben Bernanke. Bernanke has already acquired the moniker of “Helicopter Ben” after he made a passing reference in a 2002 speech to economist Milton Friedman’s famous line that deflation could be countered by dropping money from a helicopter. Although Bernanke thankfully did not have to resort to the helicopter drop, the Federal Reserve used some of the same methods outlined in his 2002 speech from 2008 onwards to combat the worst recession since the 1930s.
In December 2008, the Federal Open Market Committee (FOMC, the Federal Reserve’s monetary policy body) cut the target federal funds rate essentially to zero. The fed funds rate is the Federal Reserve’s conventional instrument of monetary policy, but with that rate now at the “zero lower bound” – so called because nominal interest rates cannot go below zero – the Federal Reserve had to resort to unconventional monetary policies to ease credit conditions and stimulate the economy.

The Federal Reserve turned to two main types of unconventional monetary policy tools: (1) forward policy guidance and (2) large-scale asset purchases (better known as quantitative easing (QE)).

The Federal Reserve introduced explicit forward policy guidance in the August 2011 FOMC statement, in order to influence longer-term interest rates and financial market conditions. The Fed specifically said then that it expected economic conditions to warrant exceptionally low levels for the federal funds rate at least through mid-2103. This guidance led to a drop in Treasury yields, as investors grew comfortable that the Fed would hold off on raising rates for the next two years. The Fed subsequently extended its forward guidance twice in 2012, as a tepid recovery caused it to push out the horizon for keeping rates low.

But it’s the other tool, quantitative easing, that has hogged the headlines and become synonymous with the Fed’s easy-money policies. QE essentially involves a central bank creating new money and using it to buy securities from the nation’s banks so as to pump liquidity into the economy and drive down long-term interest rates. This ripples through to other interest rates across the economy, and the broad decline in interest rates stimulates demand for loans from consumers and businesses. Banks are able to meet this higher demand for loans because of the funds they have received from the central bank in exchange for their security holdings.

The timeline of the Fed’s QE programs was as follows:

Between December 2008 and August 2010, the Federal Reserve purchased $1.75 trillion in bonds, comprising $1.25 trillion in mortgage-backed securities issued by government agencies like Fannie Mae and Freddie Mac, $200 billion in agency debt, and $300 billion in longer-term Treasuries. This initiative subsequently became known as QE1.
In November 2010 the Fed announced QE2, wherein it would buy another $600 billion of longer-term Treasuries at a pace of $75 billion per month.
In September 2012, the Fed launched QE3, initially buying mortgage-backed securities at a pace of $40 billion per month, and expanding the program in January 2013 by buying $45 billion of longer-term Treasuries per month, for a total monthly purchase commitment of $85 billion.
In December 2013, the Fed announced that it would taper off the pace of asset purchases in measured steps, and concluded the purchases in October 2014.
How Other Central Banks Fought Deflation

Other central banks have also resorted to unconventional monetary policies to stimulate their economies and stave off deflation.

In December 2012, Japanese Prime Minister Shinzo Abe launched an ambitious policy framework to end deflation and revitalize the economy. Dubbed “Abenomics,” the program has three main arrows or elements—(1) monetary easing, (2) flexible fiscal policy, and (3) structural reforms. In April 2013, the Bank of Japan announced a record QE program, saying it would buy Japanese government bonds and double the monetary base to 270 trillion yen by the end of 2014, with the objective of ending deflation and achieving inflation of 2 percent by 2015. The policy objective of slashing the fiscal deficit in half by 2015, from its 2010 level of 6.6 percent of GDP, and achieving a surplus by 2020, commenced with an increase in Japan’s sales tax to 8 percent from April 2014, from 5 percent earlier. The structural reforms element may be the hardest to get going as it needs bold measures to offset the effects of an aging population, such as allowing foreign labor and employing women and older workers.

In January 2015, the European Central Bank (ECB) embarked on its own version of QE, by pledging to buy at least 1.1 trillion euros of bonds, at a monthly pace of 60 billion euros, through to September 2016. The ECB launched its QE program six years after the Federal Reserve did so, in a bid to support the fragile recovery in Europe and ward off deflation, after its unprecedented move to cut the benchmark lending rate below 0 percent in late-2014 met with only limited success.

While the ECB was the first major central bank to experiment with negative interest rates, a number of central banks in Europe, including those of Sweden, Denmark and Switzerland, have pushed their benchmark interest rates below the zero bound. What will be the consequences of such unconventional measures?

Intended and Unintended Consequences

There is little doubt that the torrent of cash sloshing about in the global financial system as a result of QE programs and other unconventional measures have paid off in spades for the stock market. Global market capitalization exceeded $70 trillion for the first time in April 2015, representing an increase of 175 percent from the trough level of $25.5 trillion in March 2009. The S&P 500 has tripled over this period, while many equity indices in Europe and Asia are currently at all-time highs.

But the impact on the real economy is less clear. In the United States, the economy is expected to grow at 3.1 percent in 2015 and 2016, up from a 2.4 percent growth pace in 2014, according to International Monetary Fund forecasts. But although unemployment is down to 5.5 percent, after nearing double-digits at the depths of the recession, and housing has staged a solid recovery, the economy still seems to sputter from time to time. In Japan, the April 2014 tax hike led to an unexpected 0.1 percent contraction in the economy.

Meanwhile, the concerted moves to fend deflation globally have had some strange consequences:

Central bank balance sheets are bloating: Large-scale asset purchases by the Federal Reserve, Bank of Japan, and the ECB are swelling up their balance sheets to record levels. The Fed’s balance sheet has grown from less than $1 trillion in August 2008 to $4.5 trillion in April 2015. Shrinking these central bank balance sheets may have negative consequences down the road.
QE could lead to a covert currency war: QE programs have led to major currencies plunging across the board against the U.S. dollar. With most nations having exhausted almost all their options to stimulate growth, currency depreciation may be the only tool remaining to boost economic growth, which could lead to a covert currency war (see “What is a currency war and how does it work?”).
European bond yields have turned negative: More than a quarter of government debt issued by European governments, or an estimated $1.5 trillion, currently has negative yields. This may be a result of the ECB’s bond-buying program, but it could also be signaling a sharp economic slowdown in future.
The Bottom Line

The measures taken by central banks seem to be winning the battle against deflation at the present time (May 2015), but it is too early to tell if they have won the war. An unspoken fear is that central banks may have expended most, if not of all of their ammunition, in beating back deflation. If this indeed proves to be the case in the years ahead, deflation could be an exceedingly difficult foe to vanquish.

 

FROM INVESTOPEDIA – EFFECTS OF DEFLATION

When most of us think of inflation, we think of rising prices that strain budgets and take away our buying power. During the late 1970s and early 1980s, inflation skyrocketed as high as 14.8% in the U.S. and interest rates climbed to similar levels. Few living Americans know what it’s like to face the opposite phenomenon – deflation.

Since too much inflation is generally regarded as a bad thing, wouldn’t it follow that deflation might be good thing? Not necessarily, since much depends on the cause and circumstances of the deflationary cycle and how long it lasts. (Deflation has continued to pop up throughout economic history – but is that such a bad thing? Learn more in The Upside Of Deflation.)

What Is It?
Deflation is a general decline in prices as a function of supply and demand for products, and the money used to buy them. Deflation can be caused by a decrease in the demand for products, an increase in the supply of products, excess production capacity, increase in the demand for money, or a decrease in the supply of money or availability of credit.

Decreased demand for products can manifest itself in the form of less personal spending, less investment spending and less government spending. While deflation is often associated with an economic recession or depression, it can occur during periods of relative prosperity if the right conditions are present.

Practical Application
If prices are dropping because a product can be produced more efficiently and cheaply in greater quantity, that’s viewed as a good thing. An example of this is consumer electronics which are far better and more sophisticated than ever. Yet prices have consistently dropped as the technology improved and spurred more demand. (Learn more in our Economics Basics Tutorial.)

The effect on prices by fluctuations in the demand for money is usually a function of interest rates. As the demand for money increases during a period of inflation, interest rates rise to compensate for the higher demand and to keep prices from rising further. Conversely, deflation will result in lower interest rates as the demand for money drops. In that case, the goal is to spur buyer demand to stimulate the economy.
The Great Depression
Severe economic contraction during the Great Depression resulted in deflation averaging -10.2% in 1932. As the stock market began to crater in late 1929, the supply of money declined along with it as liquidity was drained from the marketplace.

Once the downward spiral had begun, it fed on itself. As people lost their jobs, this reduced the demand for goods, causing further job losses. The decline in prices wasn’t enough to spur demand because rising unemployment undercut consumer purchasing power to a far greater degree. The snowball effect didn’t stop there, as banks began to fold as loan defaults rose dramatically.

As banks stopped lending money and credit dried up, the money supply contracted and demand tanked. Although the demand for money remained high, no one could afford it because the supply had shrunk. Once this vicious cycle took hold, it lasted a decade until the beginning of World War II.

Possible Effects
There are many reasons to be concerned about a prolonged deflationary period, even without an event as devastating as the Great Depression:

1. Demand for goods decreases since consumers delay purchases, expecting lower prices in the future. This compounds itself as prices drop further in response to decreasing demand.

2. Consumers expect to earn less, and will protect assets rather than spend them. Since 70% of the U.S. economy is consumer-driven, this would have a negative effect on GDP.

3. Bank lending drops since borrowing money makes less sense in regards to the real cost. This is because the loan would be paid back with money that is worth more than it is now.

4. Deflation ensures that borrowers which loot to purchase assets lose since an asset becomes worth less in the future than when it was bought.

5. The more indebted you are, the worse your condition since your salary will likely decline while your loan payments remain the same.

6. During inflation, there is no upper limit on interest rates to control the inflation. During deflation, the lower limit is zero. Lenders won’t lend for zero percent interest. At rates above zero, lenders make money but borrowers lose and won’t borrow as much.

7. Corporate profits usually drop during a deflationary period, which could cause a corresponding decrease in stock prices. This has a ripple effect to consumers who rely on stock appreciation and dividends to supplement their incomes.

8. Unemployment rises and wages decline as demand drops and companies struggle to make a profit. This has a compounding effect throughout the entire economy.

What to Do
Ever since the Great Depression, there has been a continuing debate on how best to combat recessions and deflation. Federal Reserve Chairman Ben Bernanke has adopted a policy of “quantitative easing,” which essentially amounts to printing money to buy U. S. Treasuries. Following Keynesian economic theory, he is using the money supply to offset the economic contraction that resulted from the financial meltdown in 2008 and the bursting of the housing bubble. How this plays out remains to be seen since these policies are designed to cause inflation.

If the U.S. were to enter a sustained deflationary cycle, your best protection is to hold onto your job and have as little debt as possible. You don’t want to be locked in to paying off a loan with money that is increasing in value every day. Save as much money as possible and defer discretionary purchases until prices are lower. Finally, consider selling assets that you don’t need while they still have value.

HOW TO COMBAT INFLATION

Governments and central banks generally target an annual inflation rate of 2-3% in order to maintain economic stability and growth. If inflation “overheats” and prices rise too rapidly, restrictive or ‘tight’ monetary and fiscal policy tools are employed. If prices begin to fall generally, as is the case with deflation, ‘loose’ or expansionary monetary and fiscal policy tools are used. These sorts of tools, however, are potentially more difficult to employ due to technical and real-world limitations.

Deflation is a serious economic issue that can exacerbate a crisis and turn a recession into a full-blown depression. When prices fall and are expected to drop in the future, businesses and individuals choose to hold on to money rather than spend or invest. This leads to a drop in demand, which in turn forces businesses to cut production and sell off inventories at even lower prices.

Businesses layoff workers and the unemployed have more difficulty finding work. Eventually, they default on debts, causing bankruptcies and credit and liquidity shortages known as a deflationary spiral. This scenario is scary, and policymakers will do whatever is necessary to avoid falling into such an economic hole. Here are some ways that governments fight deflation.

Monetary Policy Tools

Lowering bank reserve limits

In a fractional reserve banking system, as in the U.S. and the rest of the developed world, banks use deposits to create new loans. By regulation, they are only allowed to do so to the extent of the reserve limit. That limit is currently 10% in the U.S., meaning that for every $100 deposited with a bank, it can loan out $90 and keep $10 as reserves. Of that new $90, $81 can be turned into new loans and $9 kept as reserves, and so on, until the original deposit creates $1000 worth of new credit money: $100 / 0.10 multiplier. If the reserve limit is relaxed to 5%, twice as much credit would be generated, incentivizing new loans for investment and consumption.

Open market operations

Central banks buy treasury securities in the open market and, in return, issue newly created money to the seller. This increases the money supply and encourages people to spend those dollars. The quantity theory of money states that like any other good, the price of money is determined by its supply and demand. If the supply of money is increased, it should become less expensive: each dollar would buy less stuff and so prices would go up instead of down.

Lowering the target interest rate

Central banks can lower the target interest rate on the short-term funds that are lent to and among the financial sector. If this rate is high, it will cost the financial sector more to borrow the funds needed to meet day-to-day operations and obligations. Short-term interest rates also influence longer-term rates, so if the target rate is raised, long-term money, such asmortgage loans, also becomes more expensive. Lowering rates makes it cheaper to borrow money and encourages new investment using borrowed money. It also encourages individuals to buy a home by reducing monthly costs.

Quantitative easing

When nominal interest rates are lowered all the way to zero, central banks must resort to unconventional monetary tools. Quantitative easing (QE) is when private securities are purchased on the open market, beyond just treasuries. Not only does this pump more money into the financial system, but it also bids up the price of financial assets, keeping them from declining further. (See also: Why Didn’t Quantitative Easing Lead to Hyperinflation.)

Negative interest rates

Another unconventional tool is to set a negative nominal interest rate. A negative interest rate policy (NIRP) effectively means that depositors must pay, rather than receive interest on deposits. If it becomes costly to hold on to money, it should encourage spending of that money on consumption, or investment in assets or projects that earn a positive return. (For more, see: How Unconventional Monetary Policy Works.)

Fiscal Policy Tools

Increase government spending

Keynesian economists advocate using fiscal policy to spur aggregate demand and pull an economy out of a deflationary period. If individuals and businesses stop spending, there is no incentive for firms to produce and employ people. The government can step in as spender of last resort with hopes of keeping production going along with employment. The government can even borrow money to spend by incurring a fiscal deficit. Businesses and their employees will use that government money to spend and invest until prices begin to rise again with demand.

Cut tax rates

If governments cut taxes, more income will stay in the pockets of businesses and their employees, who will feel a wealth effect and spend money that was previously earmarked for taxes. One risk of lowering taxes during a recessionary period is that overall tax revenues will drop, which may force the government to curtail spending and even cease operations of basic services. There has been conflicting evidence as to whether or not general and specific tax cuts actually stimulate the real economy. (For more, see: Do Tax Cuts Stimulate The Economy?)

The Bottom Line

While fighting deflation is a bit more difficult that containing inflation, governments and central banks have an array of tools they can use to stimulate demand and economic growth. The risk of a deflationary spiral can lead to a cascade of negative outcomes that hurt everyone. By using expansionary fiscal and monetary tools, including some unconventional methods, falling prices can be reversed and aggregate demand restored.