Deflation has emerged as a major risk to the global economy with it being particularly evident in Europe and Japan where leaders have found it hard to come up with any solutions to generate economic growth. In Europe inflation was just 0.3% in September well below the 2% target of the European Central Bank. With this low rate any weakness in the Germany economy could tip the Euro economy over the edge into a deflationary downturn. The extent of the concern with deflation was evident by the ECB’s record low interest rates – 0.05% – and a negative rates for deposits. With austerity measures in place in France and Italy one wonders about their ability to bring about any sort of growth and ultimately some mild inflation.
Why is deflation a concern?
1. Holding back on spending: Consumers may opt to postpone demand if they expect prices to fall further in the future
2. Debts increase:
• The real value of debt rises when the general price level is falling and a
higher real debt mountain can be a drag on confidence
• Mortgage payers on fixed mortgage interest rates will see the real cost of servicing their debt increase
3. The real cost of borrowing increases: Real interest rates will rise if nominal rates of interest do not fall in line with prices
4. Lower profit margins: This can lead to higher unemployment as firms seek to reduce their costs.
5. Confidence and saving: Falling asset prices such as price deflation in the housing market hit personal sector wealth and confidence – leading to further declines in AD. Higher savings can lead to the paradox of thrift