Most everyone knows that price inflation is a menace and must be combatted at all costs. Those of us who recall the 1970s and 1980s well remember how damaging it can be and how difficult it is to subdue. Yet today, global policymakers are concerned with the risk of the opposite phenomenon, deflation, which begs the question: if inflation is the enemy, what's wrong with deflation?
Examples abound of severe episodes of inflation, particularly following periods of global conflict. Germany, for example, suffered an extreme bout of hyperinflation in the aftermath of World War I. In 1914, one U.S. dollar would buy four German marks. By 1923, that same dollar would buy four trillion marks, and German families literally needed a wheelbarrow full of cash to buy a loaf of bread.
In response to such periods of devastating destruction of purchasing power, modern central banks adopted the burden of maintaining price stability through control of the money supply and of interest rates. In practice this has typically meant fighting against inflation, as we saw in the United States during the 1970s and early 1980s. Everyone who has experienced serious inflation well understands the reasons that policymakers fight so hard to resist it.
Deflation, on the other hand, is a systemic decline in prices throughout the economy, and a concomitant increase in purchasing power of the currency. This might seem like a good thing, and for short periods in moderation can be beneficial. What economists worry about are sustained episodes of lower prices and the damage inflicted upon economic growth and income.
Broadly speaking, deflation makes buyers hesitant to spend, since they believe they may be able to buy the same goods later at a lower price. Once this belief becomes widespread, then demand declines, output falls, and the economy contracts. If the situation becomes dire enough (as in the 30 percent price decline during the Great Depression), rebooting economic growth in the face of declining wages and high unemployment is extremely difficult and frustratingly slow.
One reason for the retarding effect of price deflation is the unwillingness of businesses and households to take out loans. During inflationary periods, borrowers are happy to repay their debts with cheaper dollars in the future thanks to the devaluation of the currency over the life of the loan. Lenders meanwhile simply add an "inflation premium" to the stated loan rate to compensate for the expected inflation.
During deflation, however, borrowers know they will be repaying their debts with more expensive dollars in the future. And while lenders can boost interest rates during inflation, they can hardly reduce them below zero during a significant deflation. Sustained deflationary pressure leads inevitably to loan defaults and bankruptcies.
During the 2008 financial crisis and its aftermath, the U.S. Federal Reserve worried explicitly about the possibility of deflation and took unprecedented actions to attempt to stave off such a scenario. Today, central banks elsewhere in the world (notably the European Central Bank) are taking some of the same actions used by the Fed in an effort to manufacture some degree of inflation (typically aiming for a 2 percent annual inflation target). The recent collapse in commodity prices has these policymakers on high alert for signs of destructive deflation that could arrest an already sluggish global economy.
Inflation is undeniably bad, especially for retirees. But its counterpart deflation can be equally devastating in terms of wages, investment and production if allowed to persist. Just like Goldilocks, stable economies prefer prices that are neither too hot nor too cold.
Christopher A. Hopkins, CFA, is a vice president and portfolio manager for Barnett & Co. in Chattanooga.