• Home ::
• Fundamental ::
• Analysis Reports ::
• Economic Monthly Report

• Send
• Print
• Add To
• Rss

Economic Monthly Report

25774272-b2b0-4f5a-967e-370c2d7b60a3

11

0

Fear of deflation

Thu, Mar 19 2009, 07:24 GMT
by La Caixa Economic Research Dept.

La Caixa

Inflation rates in most advanced countries have dropped to lows that have not been recorded for many years. This is a development in keeping with the recession now affecting the world economy. In fact, in periods of cyclical contraction we can expect a decrease in inflation. Up this point then there is nothing to report. However, the forecast that inflation rates are going to move into negative ground in coming months, along with concerns that the recession could be deeper and last longer than expected has set off a fear of deflation. Specifically, the fear is that there could be a spiral with a general decrease in prices of goods and services combined with a prolonged period of stagnation or recession. Last century left behind very few historical records of a phenomenon of this kind in what are currently considered the developed economies. But those that occurred were significant – the United States in the Thirties and Japan in the Nineties.

To speak of deflation we have to dig deep into the past. Since the middle of last century the big concern of economic policy has been inflation. And even before then, many historians attribute the rise of Nazism and subsequently the cause of World War II to Germany’s hyperinflation in the Twenties. Both phenomena, inflation and deflation, finally have the same monetary origin. Up until the early decades of the 20th century, money in circulation was controlled by the precious metal standard, either gold or silver. With the progressive substitution of the precious metal standard by the fiduciary issue backed by a national central bank, the volume of money in circulation lost its link with precious metal reserves. Discretionary power in monetary management often resulted in an excess of money supply which until very recently brought about firm inflationary prospects.

But, if inflation was so bad, why is deflation likewise so bad? For a number of reasons. It tends to delay consumption and investment decisions. If such and such a product will have a lower price tomorrow, why buy it today? It increases the real value of debts which brings about pressure on those in debt that may result in an increase in losses and bankruptcies. In a deflationary situation, the price of assets tends to decrease which reduces the value of loan guarantees and therefore increases the losses of financial institutions through default. This means lower availability of credit and less economic activity. Furthermore, as wages show downward rigidity, company margins grow narrower which brings about less investment and less employment. One more evil is the «liquidity trap» into which one can fall when the central bank cuts its rates to the maximum (as low as 0%) so that the best asset to invest in is cash, which carries no risk and has positive real profitability. Finally, persistent deflation is closely linked to a prolonged economic depression, something that Japan well knows.

In any case, we should say that at this moment the risk of a deflationary spiral is a long way off. Firstly, because foreseeable negative rates for consumer price indices in coming months are only the result of the effect of the collapse in oil prices since last summer whereas underlying inflation (the more stable core of inflation) is showing positive rates. In this respect, it is hardly worth talking about deflation. Secondly, because, in the face of the recession in the advanced economies, monetary and fiscal policies have been firmly set in motion, having very much in mind the lessons learned from the Great Depression and from Japan. With this baggage, we may be confident that deflation will continue to be a chapter in the history books.

• Download full Economic Monthly Report with charts

Published on  Thu, Mar 19 2009, 11:23 GMT