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Who’s afraid of the big, bad (deflationary) wolf?

The Eurozone officially fell into deflation again in February, despite the best efforts of the European Central Bank (ECB). ECB president Mario Draghi is expected to announce further measures on Thursday to try to pull Europe out of its deflationary funk. But why are central banks and economists so afraid of low inflation and deflation? For several good reasons.

The first is the dangerous way that deflation interacts with debt. If you have a debt then you need to directly repay what you owe: EUR100 ($109) of debt requires EUR100 ($109) to pay back. That’s obvious, but consider what happens when prices are moving either up (inflation) or down (deflation).

In an inflationary environment, the price of what you want to buy is rising so the EUR100 ($109) in your pocket will buy less. However, the real value of a EUR100 ($109) debt decreases, which is great because it’s now easier to repay your debt.

But everything is flipped if you have deflation: the real value of your debt slowly increases over time. This isn’t great.

...everything is flipped if you have deflation: the real value of your debt slowly increases over time.

Debtors end up cutting back on spending elsewhere just to pay off their growing debt. That means they are not investing and more likely to default or go bankrupt. It also means that those wishing to borrow in the future – a person planning to buy a house or a company wanting to invest in new machinery, for example – will be less inclined to do so because they know their debt is going to grow. All of this hurts the economy.

This phenomenon is known as ‘debt deflation’ but, confusingly, Europe doesn’t even need to be experiencing deflation for it to suffer its negative effects. The ECB sets an inflation target of just below 2%.

Companies and individuals therefore have a reasonable expectation that inflation will be around 2% and they enter into agreements to borrow money based on this expectation.

But if this target is consistently missed, then the amount of the debt that is owed is larger than anyone had planned for. That gives borrowers the same problem they would have if there was deflation: the debt is bigger than they had planned for because they don’t have the 2% cushion.

That’s why people are so worried about ‘lowflation’: when inflation is lower than what the central bank targets.

The second major reason to worry about deflation is that it tends to lead to more unemployment. If the price that a company can sell a product or service for keeps falling, the company will be forced to cut costs.

Management’s natural response could be to cut wages to maintain a particular profit margin, but company bosses often eschew this option for understandable reasons (cutting employee wages can hit morale hard). They tend to reduce the number of people they employ by laying people off and not employing any more, thus increasing unemployment.

Given all of this, it’s not surprising that central banks aim to avoid deflation. But there’s a limit to their powers and this is the most pernicious threat of deflation.

Central banks adjust the interest rate they set as a way of bringing inflation into line with where they want it to be. But they can only cut rates so far (we used to think that was to zero but, turns out, they can go below zero).

If the central bank is unable to cut rates as quickly as inflation is falling then inflation-adjusted interest rates may actually increase – a tightening in monetary conditions. That means you can reach a point where inflation continues falling because the central bank has cut its interest rate as much as it can.

The economy can then slide into a self-fulfilling spiral where the price of goods falls, inflation-adjusted interest rates increase, the economy weakens, prices fall further, interest rates increase further, and so on.

This explains why the ECB is so desperate to boost inflation today, so the trap doesn’t set in tomorrow. Deflation is the wolf at Europe’s door and the ECB is right to do everything it can to fight it off.

Important Information

Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks.

Image credit: © Corbis

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