The COVID-19 Diaries – Week 10 – ‚Deflation– the “ogre” in the world economy‘
“If inflation is the genie, then deflation is the ogre that must be fought decisively” – Christine Lagarde, 2014
Deflation substantially influenced economic crises in the last century, affecting both the Great Depression of the 1930s (on global scale) as well as the Lost Decade in Japan in the 1990s (on national scale). While policy-makers can rely on several economic measures to deal with inflation especially regarding the low interest rates, measures to deal with deflation are scarce and limited.
What are the dangers of deflation?
Deflation can derive from increasing productivity and oversupply of goods and services, from a decrease in the demand or from an undersupply of money and credit in an economy.
- With prices for goods and services decreasing over a long period of time, the economic activity may continually slow down.
- If consumers expect further drops in prices for goods and services, they will postpone their spending.
- The delayed spending will affect the companies’ bottom line and may result in fewer investments and cost-cutting (including wages).
- Moreover, dealing with the debt burdens of governments, corporates and households will become strenuous, if interest rates are constant, but prices and wages decrease. The lower the inflation the more expensive will be the debt repayment.
- The deficient outlook on the labour market and the reduced household income will cause consumers to refrain from spending and thereby the downward pressure on prices further increases.
- Ultimately, and given that governmental measures remain ineffective, the entire economy may be afflicted.
Why are we talking about deflation in the context of COVID-19?
When observing the central banks’ expansionary monetary policies aimed at funding the extensive government expenditures worldwide as well as the plummeting production outputs during lockdowns, one might be tempted to consider inflation as a major risk in the crisis. However, several factors point at deflation being the “ogre” in the world economy:
The drop in the demand for certain goods and services has superseded the shortfall in supply. Consumers cannot spend their money on industries affected by the lockdown such as travelling and restaurants anymore. In the short-term, instead of spending their money on other goods and services, many consumers choose to delay spending and save. In the long-term, while lock-down restrictions are slowly eased and production and shops are re-opened, the extensive job losses and the devastated consumer confidence around the globe will most probably have a persisting effect on the demand.
The current deflationary pressures on prices hence stem from the demand side. The falling prices can be primarily observed on global commodity markets as well as in sectors like airline, leisure, tourism, and housing, which have taken the strongest hit from the crisis. Evidently, due to rising demand, prices for food have shown an upward movement.
- Inflation has sunk below the target of 2% in the United States and is expected to substantially decrease in the Euro area and Japan in the next months.
- In China, the producer price index decreased by 3.1% compared to 2019. This reflects both the decreasing industrial demand and the drop in crude oil prices, demonstrating the severe impact of price decreases on the world economy.
- In the CESEE region, higher GDP growth fuelled inflation in the last year, however, the downward pressure on prices due to the COVID-19 impact could already be observed in Mar20.
From an investment spending perspective, the risk of entering a liquidity trap, in which lowering the interest rates becomes ineffective in the creation of economic stimulus, has already been high during the last years. Such a liquidity trap can lead to a deflationary spiral of falling prices, increased saving and delayed spending and the risk remains utterly relevant also in times of crisis.
While many experts estimate that the risk of a deflation is higher than the risk of inflation, it cannot be entirely disregarded. It may occur in the less likely case that inflation rises while central banks are bound to maintain low interest rates to finance government spending. Keeping a balance between spurring growth and limiting inflation, while handling the debt burdens will hence remain a challenge for policymakers. However, assuming constant levels of interest, the repayment of household, corporate and governmental debt becomes even more puzzling if prices and wages drop in the scenario of deflation.
- Financial Times
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