A surprise drop in the consumer price index , as well as a fall in wage growth has seen the term “deflation” bandied around in recent weeks. It’s an issue that has plagued central bankers abroad for some time.
But what is deflation? And why is it such a worry? Below are a few answers.
What is deflation?
It’s when prices go backwards for a sustained period, pulling the inflation rate into negative territory below 0 per cent.
What’s wrong with falling prices?
Falls on individual prices to induce spending can be healthy but falls on the majority of prices can have the opposite effect. If I know that the cost of a big purchase will potentially be lower over the medium to long-term, my incentive is to hold off from spending. When you multiply this effect across an economy, you get a pronounced slowdown in consumption.
So it’s just about price falls on goods?
No, deflation has a more dire effect on lending. Deflation increases the real value of debt, which means more money is required to cover future loan payments. Zero interest rates provide tepid incentive for a bank to lend. Finally, deflation reduces the value of collateral held by the bank. All of this makes businesses, banks and consumers wary of lending and borrowing. Without credit and loans being written, growth and expansion stalls, putting a further brake on economic activity.
Why is the inflation rate dropping?
After the GFC central banks around the world slashed rates to ultra-low levels to spur growth. However, high levels of debt held by governments and consumers, and uncertainty about future growth and jobs have prevented rate cuts from having their desired effect. Instead, rates remain low as growth slows and inflation sputters. The eurozone first drifted into deflation two years ago. The more recent crash in oil prices has removed further upward price pressure because energy is a major component of inflation in the measure of price changes.
Is deflation happening in Australia?
So far not in any meaningful way. Prices fell in Australia for the first time in seven years in the March quarter, when the CPI contracted 0.2 per cent. But it’s what’s over the horizon that has some economists nervous. The end of the mining boom has seen plunges in the values of commodities crucial to Australia’s economy and budget. With neither prices, nor demand high the risk of deflation in Australia can’t be written off.
Will deflation last?
Deflation has bedevilled Europe for a few years, and Japan for many years, so the risk of deflation coming to Australia can’t be ignored. However, a single quarter of price falls doesn’t mean deflation. A Bloomberg consensus sees the inflation rate at a respectable 2.5 per cent in a year’s time. Nonetheless, at least one overseas analyst, London-based Alberto Gallo of Algebris Investments, believes Australian interest rates could be heading for 0 per cent, driven by the hangover of over-investment during the mining boom and China’s slowdown. If this happened, the chance of deflation would likely be greater.
If a country’s inflation falls into negative territory for an extended time, it can create a vicious cycle, where diminished consumption restrains borrowing and lending. In an economy dealing with deflation, employee resistance to cuts or reductions in their pay (to match price falls) also increases costs for companies. Deflation blunts the effectiveness of interest rate changes by the central bank. The textbook example of an economy facing prolonged deflation is Japan, where deflation and weak growth have hampered a strong recovery
Will Australia turn Japanese?
Japan has other problems which make deflation worse including a property bust in the early 1990s that crippled many interlinked lending consortiums and a rapidly ageing population which is shrinking. By contrast, while Australia’s population is ageing, immigration is increasing. Nonetheless, the global slowdown and a pullback in commodities are two factors likely to weigh on Australia, a country exposed both to the resources markets and China’s overall health. The extent of the problem – if there is a problem – will be known in the months ahead.