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Deflation
The Trouble With Falling Prices
By Simon Kennedy | Updated Jan 22, 2015
The ogre stalking Europe’s weak economies isn’t the one people have learned to fear. The monster
isn’t inflation but its opposite: falling prices. Its name is deflation and it appears friendly. Why be
afraid when the cash in people’s wallets buys more fuel and televisions, not less? Because when
deflation grabs hold, companies and consumers can stop spending. It strangles borrowers because
their debts get harder to repay — a menace for countries struggling to exit the worst recession in a
generation. In this fairy tale, inflation comes dressed in shining armor as policy makers debate how
to create just enough of it to keep deflation at bay.
The Situation
Six years after the 2008 financial crisis turned the global economy upside down, a slide in prices
threatens to drag out the turmoil. Europe’s central bank unveiled a bond-buying plan on Jan. 22 in a
once-and-for-all push to revive inflation. The continent’s economies have failed to recover the
momentum needed to stimulate slow-but-steady price increases, which most central bankers
consider desirable. Consumer prices in the euro area fell for the first time in more than five years in
December. The slide in oil is adding to the deflationary pull and prices are expected to drop further in
2015. About a third of the goods that Europeans commonly buy are declining in price, including
clothes and carpets, according to Jefferies International. In Japan, inflation only began showing signs
of life in 2013 as the central bank targeted a 2 percent price gain in an all-out bet to shake off more
than a decade of deflation and stagnation. Japan fell back into recession in 2014 and inflation risks
slipping anew after an increase in the consumption tax.
The Background
When prices rise at a slower pace it can help consumers boost their purchasing power. But when
they actually drop, economic activity can screech to a halt. Companies postpone investment and
hiring as they are forced to cut prices. Sliding prices eat into sales and tax receipts, limiting pay raises
and profit margins. They add to the debt burdens of companies and governments that would
otherwise be eroded by inflation. Deflation fueled two of the worst economic disasters in modern
times — the Great Depression of the 1930s, and the less catastrophic but more recent experience of
Japan’s lost decades with almost no economic growth. Deflation took hold in Japan in the 1990s
when banks, wounded by a burst real estate bubble, stopped lending. Wages stagnated and
consumers reined in spending. The International Monetary Fund has studied which economies are
vulnerable to deflation, and has raised concern that even a period of ultra-low inflation could do
damage. “If inflation is the genie,” IMF Managing Director Christine Lagarde warned in January 2014,
“then deflation is the ogre that must be fought decisively.”
The Argument
Central bankers find it easier to beat inflation than deflation. When prices rise too fast, policy makers
raise interest rates, then pull back when the economy slows. It’s harder to calibrate the right dose of
medicine to ward off deflation. Interest rates in most large countries are still near zero, and the
European Central Bank even cut a key rate into negative territory in June 2014. In Greece, deflation
may be a price worth paying to make the country competitive again after years of living beyond its
means. Bond-buying programs like those that helped revive the U.S. and Japan have also had
dangerous side effects. They’ve sent money flowing into stocks and property, boosting the prices of
assets rather than products, raising concern that too much easing was creating bubbles. Even
so, when the threat of deflation seems small, history tells us that it’s a huge risk.
The Reference Shelf
 Former U.S. Federal Reserve Chairman Ben S. Bernanke’s 2002 speech on deflation and his 1991
research paper on the Great Depression.
 Studies from a 2003 symposium on deflation hosted by the Federal Reserve Bank of Minneapolis.
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IMF research on the risk of deflation in the euro area and IMF Managing Director Christine
Lagarde’s speech calling deflation an “ogre.”
European Central Bank President Mario Draghi’s Feb. 6 comments playing down the risk of
deflation.