EFA (7): Deflation

Oil gets cheaper, cars get cheaper, food gets cheaper, beer gets cheaper... This sounds like it must be paradise. Yet, at the moment, many experts are very worried about the prospect of falling prices.

"Deflation" is the word on everybody's lips, and this is the subject of the seventh item in our Economics for Amateurs (EFA) series. You can find this series here every Monday.

So what exactly is deflation? Well, let's start with its opposite: inflation. Inflation is a sustained rise in the general price level. Not, you notice, an increase in the price of a particular product or service, nor a temporary rise in prices in general. Inflation is normally measured in percentage terms at an annual rate.

Deflation, then, is the opposite: a sustained fall in the general price level. Again, not a temporary fall, not a fall in the price of particular goods. And not simply a fall in the rate of inflation: that is called "disinflation".

Inflation is feared because it destroys the value of money, leads to demands for higher wages and creates uncertainty about the relative prices of different products.

But deflation also causes serious problems and can lead to an economy stagnating over a long period, as in the case of Japan in the 1990s.

If consumers expect prices to fall, they are likely to postpone their purchases if they can, which reduces demand and output. Falling prices also increase the real value of outstanding debts (for example, mortgages), which will further throttle spending.

Another problem is that deflation is likely to increase the real interest rate. This is the difference between the nominal (actual) interest rate and the level of inflation. This increases the cost of borrowing, which leads to lower investment by companies.

So, be careful what you wish for. If deflation occurs, falls in nonimal wages won't be far behind, which is psychologically very difficult for employees (even if the purchasing power of those lower wages is the same as before).

Last week, the US announced that prices had fallen in March by 0.4 per cent compared to March 2008, the first such fall since August 1955, and a sharp turnaround from the 5 per cent inflation of last August.

There was an air of mild panic that deflation had arrived. It hasn't, because the price fall isn't (yet) a sustained one. And excluding food and oil prices, "core inflation" is still positive, at 1.8 per cent.

But you can be sure that governments and central banks around the world will do all they can to prevent deflation from setting in — by expanding demand and printing money — even at the risk of increasing future inflation.

PS: Confusingly, there is another meaning of deflation in economics — a deliberate policy by governments to reduce the level of demand to control inflation. This is definitely not on the agenda at the moment.