Why Deflation Is a Downer

Ethan Harris is a global economist with Bank of America Merrill Lynch.

Inflation has been low for a long time, and we keep hearing about the possibility of deflation. Why is that a concern?

Deflation occurs when prices and wages are falling. It’s not just what you pay at the store, it’s also what you get paid by your boss. The weakness in income is the dangerous thing. People may find it hard to repay their debts, or they may delay making big purchases. We’ve seen that happen in Japan: It has meant a stagnant economy, creating the “lost decade” there.

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Are we at risk here in the U.S.?

As we start to see better growth in the economy, deflation worries will fade away. But the risk lurks in the background. We’re one major shock away from falling into deflation. It could happen if the U.S. economy falls into another recession, if things fall apart in Washington again, or some geopolitical event occurs—all the kinds of bad things that can happen every once in a while. Even a period of weak economic growth in which unemployment rises again could kick off deflation. I’m relatively optimistic these shocks won’t occur. We have a good chance of finally getting a couple of good years of economic growth in the U.S. But the European Union has gone through its second recession in five years and faces a serious risk of deflation.

If Europe falls into deflation, how does that affect the U.S.?

The danger is that a European deflation will reignite the debt crisis over there, and panic in Europe will spread to global markets, as we experienced a couple of years ago. Europe is an important U.S. trading partner, and trouble in one region can lead to financial troubles in others.

If we were to fall into deflation here, what would the impact be on savings and investments?

As long as the economy is in the limbo state it’s in now, the returns on short-term investments such as bank accounts will be extremely low. If we go into deflation, it would be tough on the stock market, too.

How would you turn deflation around? Can central bankers stop it?

The way to stop deflation is to heal the economy and get a strong recovery in jobs and wages. At this stage, the Federal Reserve Board has done all it can to get the economy to grow, and some people worry that the stimulus will trigger inflation. But what the Fed really wants is strong wage and income growth, and along with that comes growth in the prices of goods and services.

Nellie joined Kiplinger in August 2011 after a seven-year stint in Hong Kong. There, she worked for the Wall Street Journal Asia, where as lifestyle editor, she launched and edited Scene Asia, an online guide to food, wine, entertainment and the arts in Asia. Prior to that, she was an editor at Weekend Journal, the Friday lifestyle section of the Wall Street Journal Asia. Kiplinger isn't Nellie's first foray into personal finance: She has also worked at SmartMoney (rising from fact-checker to senior writer), and she was a senior editor at Money.