In the MPC's last monthly inflation report they forecast that inflation could fall to 1%. They even hinted at the possibility of deflation. What is deflation and why does it strike fear into economists and policy makers?
Deflation is simply a fall in the general price level. If this deflation a result of improved productivity and greater efficiency, it could be benign. But, usually deflation is caused by falling demand and lower growth. It is no coincidence that our worst period of deflation was in the great depression of the 1930s. This kind of deflation is very damaging because:
- Lower Spending. When prices are falling, there is an incentive to delay purchases. Why buy a TV now, when it will be cheaper in 12 months? Look at how the housing market is suffering because of falling prices. Nobody wants to buy with falling house prices; this is why property transactions have slumped and of course causes further falls in prices. In Japan, the decade of deflation created a culture of thrift and saving. Japanese housewives just wouldn't spend. Tax cuts, government spending and interest rate cuts all failed to stimulate growth because all the Japanese wanted to do was save (an example, of the Paradox of thrift)
- Liquidity Trap. A liquidity trap occurs when lower interest rates fail to stimulate spending. If prices are falling by 2%, it can be more attractive to save money in cash then spend. Therefore, cutting interest rates to 0% may be ineffective in increasing demand.
- Increasing Burden of Debt. If you take out a mortgage and make mortgage payments of say £500 a month, inflation will progressively reduce the real value of your mortgage interest payments. High inflation thus makes a mortgage more attractive, over time, it increases the disposable income of mortgage owners.
- However, with deflation, this £500 a month becomes a bigger % of your disposable income. In deflation, debt becomes an increasing burden reducing spending and economic growth.
- The problem is that the UK and US are increasingly indebted, personal savings are very low. Personal debt is very high therefore, deflation would be very damaging for an economy burdened with a legacy of debt.
- 4. Rising Real Wages. Workers will general seek to prevent a cut in nominal wages. Therefore, with deflation, real wages rise by stealth. This can lead to real wage unemployment. With deflation, it is much more difficult for prices and wages to adjust.