Definition: The steady drop over a period of years in the prices of goods, services and wages.
Example: Following a rapid rise in the value of American homes, prices peaked in June of 2006. From that point they’ve deflated, sliding in value slowly and steadily. By the end of 2010, home values dropped a total of 26%, actually exceeding the fall experienced during the Great Depression.
Investeach explains: Inflation is commonly thought of as “Public Enemy #1” because when prices go up, our money buys less and less. That makes all of us poorer. However, we may have to demote it to #2. Let’s take a hint from central banks, the entities within each country charged with regulating the economy. They’d much rather contend with inflation than deflation, so that indicates how much deflation is loathed.
The reason deflation is feared most is that once it occurs, it’s thought to follow a destructive self-reinforcing downward spiral. For example, if you notice that the prices of products are falling, you will probably hold off on making purchases to get a lower price. If enough people do this, consumer spending drops, and businesses have to fire employees or at least lower their pay. This leaves them with less money to spend and pay off existing loans… and all the more interested in waiting until the future to make purchases.
Following the financial crisis which began in 2007, the United States’ Federal Reserve Bank attempted to avoid deflation by taking the following extraordinary steps: 1) lowering short-term interest rates to 0% and pledging to keep them there for an “extended period”, and 2) embarking on quantitative easing, an attempt to lower long-term interest rates.
The country of Japan experienced a deflationary cycle lasting a stunning 20 years. It has resisted all efforts to stop it, including massive borrowing and spending by the Japanese government and low interest rates that normally boost economic activity. The mark this has left on the Japanese populace cannot be overstated. It has resulted in a “culture of fatalism, pessimism, and diminished expectations”, as the New York Times put it. Japanese entering the work force in or after 1990 became victims of bad timing, becoming known as the “lost generation”.
And yet, the human spirit endures. It appears that many Japanese have simply gotten used to deflation. Companies are helping them by opening the Japanese equivalent of dollar stores. McDonald’s 100 yen menu, introduced in 2005, features a hamburger that sold for 210 yen in 1990!
Not everyone dislikes deflation. Consider that retirees whose pensions pay them the same amount of money every year can feel safe that they will be able to afford the same – or even greater – standard of living year-in and year-out if prices are dropping!
In 2013, Japan’s Prime Minister Shinzo Abe announced an ambitious program to stop deflation once and for all. His intention was to stimulate Japan’s economy by doubling its money supply in order to achieve 2% annual inflation.
Riddle me this:
1. What economic condition is thought to be “Public Enemy #1”?
2. What condition may even be worse than it?
3. What sector of the U.S. economy suffered significant deflation after peaking in 2006?
3. Explain how the deflationary cycle, once started, reinforces itself.
4. What steps did the Federal Reserve Bank take to ensure deflation didn’t take hold in the U.S after the financial crisis.?
5. What country experienced a 20+ year cycle of deflation?
6. Identify what happens to the psychology of people who live in a country that experiences a long period of deflation.
7. Identify ways that companies operating in a deflationary environment attempt to better serve customers.
8. Identify a party that actually welcomes deflation. Explain why.
9. Examining recent news headlines, assess how well Japan is doing fighting deflation.