The Risks of Deflation

Lots of chatter these days about the chance of deflation (falling prices) and the risk of a slow-growth trap in the European Union and other major economies. So how great a risk is global deflation? What would it mean to the U.S.? (Inflation here is creeping up, though still only 1.5%.) And aren’t falling prices supposed to be a good thing?

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While the chances of worldwide deflation are modest, recent trends in Europe have been worrisome. Inflation rates have been slowing in the region’s powerhouse economies over the past year. Germany’s most recent 12-month inflation rate of 1.0% was 1.4% a year ago; the UK’s rate has fallen from 2.8% to 1.6%; France’s, from 1.0% to 0.6%; and Italy’s, from 1.6% to 0.4%. Many of the European periphery countries are experiencing outright price declines: Spain, Sweden, Greece, Portugal, Slovakia, Croatia, Bulgaria and others.

Inflation rates look better in the advanced economies outside Europe, though they are still low: The rate is 1.5% in the U.S., Japan, and Canada, and 2.4% in China. Chinese producer prices, however, have been declining for two years, indicating potential oversupply in the industrial sector.

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Deflation can be good for consumers, but it’s a high-stakes risk. Once deflation takes hold, an economy can get stuck in a no-growth trap. A downward price cycle is self-reinforcing in the same way that an upward inflationary price spiral is, as Japan has cause to know. In 1999, when prices there started to slide, consumers put off planned purchases and businesses delayed investments, assuming prices would be better tomorrow. Slower consumption threw a wet blanket on output, hiring and income, which in turn dampened prices and buying even more, and Japan spent a decade struggling to grow. Two decades later, prices are still below their 1994 level, despite massive increases in both public spending and debt.

What’s more, deflation is nearly impossible to uproot. Interest rates can go only so low, and, in real terms, deflation erodes their stimulative effect. So even a slim prospect of deflation can spook investors and businesses.

The European Central Bank is preparing to do what it takes to head it off. Already, the ECB has cut its interbank lending rate (similar to the federal funds rate set by the Federal Reserve) to 0.25%. Buying up bank loans in a kind of quantitative easing, like the Fed’s QE3 bond buying, may well come next, though that will take time. Another option is for the ECB to charge a fee for banks to keep their reserves parked there, a kind of negative interest rate, meant to encourage banks to plow their reserves into the economy instead.

But there’s little margin for error in Europe. Any negative shock to the economy would likely tip it into deflation and derail the region’s slow move back to health. Failure would mean slower exports and stronger headwinds for U.S. growth. In China, any deflation preventive may be as bad for the U.S. as the disease. Because it’s only producer prices that are sliding in China, Beijing will be tempted to bolster industrial production rather than try to spur more consumer spending. That would translate into a lower value for the yuan and more exports pumped out.