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Why Deflation Is Poison for Virus-Plagued Economies

Why Deflation Is Poison for Virus-Plagued Economies

(Bloomberg) -- What could be bad about falling prices? After all, everyone wants their paycheck to stretch a little further. The problems start when cheaper cars, clothes and gadgets keep getting cheaper, a damaging downward spiral known as deflation that can wreck an economy. In the economic shock triggered by the coronavirus pandemic, the fear is that prices around the world could start falling, pushing the global economy from recession into something even harder to climb out of.

1. What’s wrong with falling prices?

When prices drop across a wide range of goods and for a long time, economic activity can screech to a halt. The more buying power shoppers think they will gain by waiting for cheaper goods and services, the more they put off buying anything at all. Delayed purchases squeeze company sales and profits, prompting firms to postpone investment and hiring and to keep a lid on wages. Poorer job prospects and stagnant pay make households stingier, putting more pressure on firms to keep prices down. Companies, workers and households all end up suffering.

2. Why do economists worry about it?

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. While economists have come up with policy solutions that can tackle inflation, they have had little success devising effective solutions for deflation. “If inflation is the genie, then deflation is the ogre that must be fought decisively,” European Central Bank chief Christine Lagarde said when she headed the International Monetary Fund.

3. What has Japan taught us about deflation?

That it is extremely difficult to escape. Falling prices 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 reluctance of consumers to spend and of companies to raise prices became the new normal. The Bank of Japan calls this a deflationary mindset. After two decades of price weakness and low growth, Prime Minister Shinzo Abe placed Haruhiko Kuroda at the helm of the BOJ to try to slay deflation once and for all. But after seven years of flooding the banking sector with cash by purchasing a mountain of assets bigger than the size of the economy, inflation still remains closer to zero than its 2% target. The addition of negative interest rates and a zero-percent bond yield target have failed to show a decisive impact, highlighting the difficulty of ending deflation with monetary policy tools alone.

4. What’s fueling deflation concerns now?

Even before the coronavirus, inflation was very weak among industrial countries despite years of aggressive monetary easing following the global financial crisis, raising fears of spreading “Japanification.” Plunging oil prices and tanking economic activity add to the concerns. While suspended factory production lines and shuttered shops will eventually reopen, job losses around the globe mean weakness in demand will persist. Government measures like cash handouts may not offer a quick prop for demand and prices while public health measures to contain the virus and safety concerns continue to keep people off the streets. The outlook is so uncertain that Fed Chairman Jerome Powell has chosen to skip the release of economic forecasts, saying publishing them “could have been more of an obstacle to clear communication than a help.”

5. What’s the effect on bonds?

In theory, deflation can make bonds more attractive for investors because a fixed stream of income is more valuable in a world of falling prices and lower interest rates. Treasuries and other high quality bonds such as AAA-rated corporate debt are often touted as deflation hedges. But things get trickier for high-yield debt, particularly if the deflationary environment increases the business risk -- and therefore credit risk -- of junk bond issuers. And while inflation can help relieve the burden of debt for companies and governments over time by reducing its real value, deflation will of course have the opposite effect.

6. Is inflation also an issue?

Some think deflation concerns triggered by the pandemic are overplayed since prices could jump as economic activity resumes and the impact of government and central bank stimulus kicks in, spurring demand. Yet, even after the pandemic is over, the scars from the shutdown -- poor jobs prospects, shattered consumer confidence and patchy recovery in global supply chains -- may prevent a quick recovery and thus keep a lid on inflation. Inflation is typically an easier challenge for central banks in major economies to cope with, because they have plenty of room to raise interest rates from current rock-bottom levels.

The Reference Shelf

  • Japanification, Secular Stagnation and Bad, Bad News: QuickTake
  • What a Liquidity Trap Is and Why We’re Looking at One: QuickTake
  • IMF research on the risk of deflation in the euro area and Lagarde’s speech calling deflation an “ogre.”
  • 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 symposium on deflation hosted by the Federal Reserve Bank of Minneapolis.

©2020 Bloomberg L.P.