Falling prices – it doesn’t sound like that could that be a problem, does it? But from an economic standpoint, deflation is actually a serious concern. Like driving below the speed limit on a busy freeway, it seems like it would be safer, but you might just cause a 25-mile traffic jam.
Deflation occurs when overall price growth becomes negative – the opposite of inflation. While that still might not sound like a problem, the paralyzed economic activity that drives deflation definitely is. And with the current growth in the prices of goods and services now at the lowest level since 2008, the likelihood of an upcoming period of deflation is increasing. Businesses would be wise to consider the possible effects of deflation on their business models.
In an economic slowdown, several unpleasant factors play out that can drive deflation:
- Businesses and consumers slow their spending, and demand for products and services falls. Case in point – witness the recent drop in demand for gasoline as people drove less due to coronavirus. Falling demand led to a large decline in oil prices as supply far exceeded demand.
- As demand drops, companies are forced to reduce their prices to entice consumers and businesses to start buying again.
- But with their revenues lowered, companies curtail investment, reduce hiring, and freeze wages.
- Debts and interest payments begin to weigh heavier as income drops, and the risk of default rises. Banks get pickier in their lending, and the lending cycle stagnates.
- The Federal Reserve’s monetary-policy tools don’t work as well during a period of deflation. To encourage spending and lending, the Fed would generally try to keep interest rates near or below the rate of inflation. But because interest rates are already very low, deflation makes that a more difficult task.
Keep that vicious cycle going for a sustained period of time and you’ve got deflation.
And after having said all that – take a deep breath, because it could be that instead of deflation, we’re in for a period of global inflation if central banks have flooded their economies with too much money as they try to prop up spending. Get the balance wrong, and it could tip the scales in either direction. Businesses should have contingency plans in place for both deflationary and inflationary scenarios.