The word "Deflation" has been missing from the English-language lexicon since the Great Depression. Now the word is coming back!This article will explore whether deflation is destined to simply remain a word in the dictionary or a word we will live with every day.
Deflation is not the same thing as "disinflation," the latter of which is defined as a downward movement in inflated prices to a more normal level.
An example of disinflation is where inflation had been running at 5% per year but is now just 2%.
Deflation, however, is a persistent decrease in the level of consumer prices or a persistent increase in the purchasing power of money because of a reduction in available currency and credit.
Deflation is defined in a general sense, since some goods and services are rising in price even during deflation.
"Given the current low level of inflation and the uncertainty of forecasts, the possibility of episodes of declining prices ... cannot be ruled out," stated the Bank of International Settlements (BIS) in its annual report on June 30.
It continued, "The successful taming of inflation has increased the possibility that most advanced industrial economies might be one deep recession away from experiencing deflation."
The BIS acts as a bank for central banks and promotes cooperation to support international financial stability.
In contrast, the recent decline in the dollar strengthens prospects for growth in the United States and lessens the probability of deflation there, it noted.
The dollar has fallen almost 35 percent from its early 2002 peak against the Euro and 12 percent against the yen over the same period.
Apparently, though, the BIS doesn't see eye-to-eye with our own Federal Reserve Board (The "Fed"). On June 25, the Fed lowered the overnight bank lending rate to 1%, the lowest level since 1958. The Fed simultaneously reduced its more symbolic discount rate to 2%.
The world"s biggest economy appears to be stabilizing but "has yet to exhibit sustainable growth," the Fed said in a statement that followed a two-day meeting of its governors.
The Fed will raise rates when it perceives inflation may get too high and will lower rates when it perceives sluggish growth in the economy. The Fed has lowered interest rates 13 times since 2000.
The Fed is trying to prevent the U.S. from following in the footsteps of Japan. Japan's stock market bubble burst in 1989, followed three years later by the start of a decline in its real estate prices.
The world's second-largest economy has been in periodic recessions for more than a decade now, accompanied by deflation on real estate and financial assets. The Central Bank of Japan has lowered its rates to nearly zero without producing a positive impact for the economy.
Is Deflation Bad?
Most people agree that deflation is bad. Deflation means that there is not enough demand for available goods and services at current prices. Companies must lower prices to stimulate demand, and this prompts people to wait and buy at lower prices they expect in the future.
When people don't buy, companies can't make a profit and must lay off employees. Borrowing money is a great idea during inflation, since the borrower can repay the funds with cheaper dollars. When deflation sets in, though, borrowers have to repay their loans with more expensive dollars, and this lessens borrowing demand.
U.S.A.'s last period of sustained, declining prices occurred during the Great Depression. Two philosophies had been battling each other since the roaring 1920s.
The "old" school taught that people should save for their future. The "new" school taught people to live for today. (Does this sound familiar?)
The pendulum swung toward the "new" school in the 1920s. After the stock market crashed starting in October 1929, people were scared and, if they weren't wiped out already in the crash, they started spending less.
During the first four years of the Great Depression, prices plunged 25%. Falling demand and prices led companies to lay off more employees. The peak unemployment rate reached 25% in 1932.
The Fed knew that the economy was sinking and reacted quickly by lowering its discount rate eight times between November 1929 and May 1931, the last one of which coincided with the collapse of a huge bank, Austria's Kreditanstalt.
(Incidentally, for those of you who love "The Sound Of Music," the real Family von Trapp lost everything when Kreditanstalt went bully-up.)
Late in 1931 and again with Roosevelt's inauguration in 1933, the Fed sensed (wrongly) that the economy was picking up steam and raised interest rates. Each time they did so, the economy stumbled further.
