Why Are People Worrying About Deflation?

Deflation is a general decline in prices. For anyone who has been struggling to make ends meet that may not sound all bad. In fact, it’s not always bad. According to the Federal Reserve Bank of St. Louis, between 1876 and 1879, prices in the United States fell by about 5 percent per year, on average, while the economy grew at a 7.6 percent clip.

The UK is often considered to have been the hardest hit during this period, losing some of its large industrial lead over the economies of Continental Europe. The average rate of growth grew at just 1.75-2.25 percent, reflecting the growing pace of industrialisation and technological progress.

Of course, deflation is not always good either. Financial crises in the UK during 1873-1879, the early 1930’s, 1959 and 1986 were followed by periods of lower economic growth and deflation. The Economist described the harmful effects of deflation like this:

“It is a pernicious threat, all the more so because, at its onset, it seems almost benign… The belief that money made tomorrow will be worth less than money today stymies investment; the belief that goods bought tomorrow will be cheaper than goods bought today chokes consumption… Wages, incomes, and tax revenue all stall, undermining the ability of households, businesses, and governments to pay their debts – debts which, in real terms, will grow more burdensome under deflation.”

Deflation is a greater threat in Europe than in the United States. The European Central Bank’s most recent bulletin distinguished between deflation (a significant and persistent decline in prices that becomes entrenched in expectations) and disinflation (a process of decelerating inflation that may lead to negative inflation rates but is a temporary state of affairs). Italy, Spain, Greece, Sweden, and Israel experienced negative inflation in September, according to The Economist. It reported, “The IMF [International Monetary Fund] recently put the odds of deflation in the euro zone – defined as two quarters of falling prices in a 12-month span – at 30 percent in the coming year.”

The rate of UK inflation (CPI) fell to 1.2% in September, its lowest rate for five years, pushed down by lower energy and food prices. It is thought inflation could fall to 1% in the UK before the end of 2014. That is seen as good news for households, where prices have risen faster than average incomes since the financial crisis.