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21 – Deflation

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21 - Deflation

 

 

Now that we know what inflation is it makes sense to do a little digging on its opposite; deflation.  In this lesson we will take a look at what deflation is and how it affects people and the economy as a whole and how central banks go about dealing with deflation.

 

In this Article:

  •         What is Deflation?
  •         Why is Deflation Bad?
  •         How Far Will Central Banks go to Control Deflation?
  •         Central Bank Mandates for Inflation and Deflation
  •         What is Disinflation?

 

What is Deflation?

First we talked about inflation, but at the other end of the scale we have something called deflation.  Essentially, deflation is the exact opposite as inflation but we won’t leave you hanging with that simplistic of a definition.  Let’s go a little bit deeper into deflation now.

Deflation is a situation where the prices of goods and services are falling year over year and could be even be going into negative territory.  This is the exact opposite of inflation because the purchasing power of the currency is usually higher than it would be in an inflationary environment.

This means that if the prices of the things you want to buy cost less than you might be able to afford them easier.  Or if you want to go on holiday abroad then you may be able to do it cheaper because your money is potentially worth more than the currency in country that you are thinking about visiting.

Typically, deflation is a contraction in the supply of money that is circulated within an economy.  If the central bank was trying to control inflation then they may have already taken steps to remove money from the economy through the various tools that they have at their disposal.  If you need a refresher go back to the lessons on central bank tools.

 

Why is Deflation Bad

You may think that deflation is a good thing because prices are going down which might make your life easier.  But the fact is deflation can be the kiss of death for the stability of an economy. The reason for this goes back to what we looked at in a previous lesson about how a strong growing economy needs constant consumer spending to keep that growth rate up.

For example, if everyone knows that the products they are thinking about purchasing are going to be cheaper next year then they may as well save their money and wait for the price to come down next year.  This means that many businesses will suffer and potentially fail because the current level of consumer spending will not be enough to support their basic operational business expenses.

If businesses are struggling to support their basic expenses then they will be forced to start laying people off.  This will in turn increase the unemployment rate which means more people will have less money to spend because less people have jobs.  If this is left unchecked, deflation can spiral out of control and ruin the ability of everyday people to be able to buy the basic consumable items they need to survive.

 

How Far Will Central Banks go to Control Deflation?

As a net effect within an economy, deflation can have a disastrous result which is why central banks will do almost anything to avoid deflation from happening.

Think back to the financial crisis and the Great Recession that kicked off in 2007. Ben Bernanke, the head of the Federal Reserve in the United States, along with the entire Federal Reserve released a monster and the largest quantitative easing program the world had ever seen just to fight its biggest fear of deflation.

The Federal Reserve literally printed several trillion U.S. Dollars, bought hundreds of billions worth of risky financial assets such as subprime and mortgage back securities, credit default swaps, and even huge financial companies in order to fight deflation.  That goes to show how just scared central banks are of deflation and how far they will go to stop an economy from drifting into deflation.

Had the Federal Reserve not gone as far as they did to stop deflation there is no telling how bad and for how long the economy would have gotten.  Many economists say that we were nearly on the verge of the entire financial system as we know it completely imploding. We will never know for sure, but at the time of this writing in early 2018 the United States is experiencing one of its best economic environments on record.

It’s worth noting that many other central banks have also launched similar quantitative easing programs in order to combat deflation within their economies as well.

 

Central Bank Mandates for Inflation and Deflation

For most major developed economies the sweet spot for inflation to be rising is generally considered to be around 2% per year.  Most central banks will have a tolerance of around 1% on either side of their target before they decide if they will need to take decisive action and steer the economy the way they would prefer.

This interest rate target is the central banks mandate and is required by law for them to do whatever it takes to make sure that the economy reaches these inflation targets.  If deflation sets in then the central bank is literally violating its mandate to the country and the nation’s citizens that it has vowed to serve. If deflation is potentially looming you can bet the central bank is arming themselves for battle.

Traditionally, the most powerful tool to tackle inflation and deflation issues is interest rates as we have been talking about a lot.  A simple way of knowing what impact inflation will have on interest rates is to remember these rules:

  •         To cut inflation you need to hike interest rates.
  •         To increase inflation you need to cut interest rates.

These two situations are inversely correlated.  This is not always the case, but for the most part this is the thought process that you should be thinking when it comes to inflation and interest rates.

Aside from the main issue of inflation central banks are of course concerned about the overall economic cycle because this plays a major part in a stable financial environment.  Economic cycles are inevitable because it’s virtually impossible to sustain infinite growth. Sooner or later the cycle will change and the economic situation will change right along with it.  This is precisely why there are cycles in the forex market.

 

Deflation and its Effects

The intermarket influences that we have have described so far are based on statistical models dating back to the 1970’s.  In the United States the 70’s was a period of runaway inflation as the government started letting the capital markets do something called “self-regulation”.  This meant that the market was free to basically do whatever it wanted. And that is exactly what it did. It went on a profit hunting spree like none other which created this inflationary environment.  This high inflation created an environment that favored commodity and stock prices to go up.

However, since the Asian markets collapse in 1997, and its subsequent spread into the global economy, commodities have been hit hard with many boom and bust cycles.  The Asian markets are such major consumers of commodities that the downturn has caused a lot of volatility within the commodities that they consume.

And this works in reverse, whenever the Asian markets are booming commodities boom right along with them.  This has caused a long term bullish run in bonds and non-commodity based equities. The idea is to remove that volatility component within portfolios that the Asian markets have created through boom and bust cycles in commodities.

 

What is Disinflation?

Disinflation is a short term slowdown in the rate of price inflation.  This describes times within the economic cycle where the rate of inflation is slowing but not to the point of becoming deflationary or producing negative readings.

Inflation and deflation refer to the direction of the prices of goods and services.  Disinflation refers to the percentage rate of change in the rate of inflation.

People tend to confuse disinflation with deflation.  Disinflation is not typically considered a major problem like deflation is because prices do not actually drop and it does not usually tell us that the economy is slowing down.

Disinflation is typically seen in an economy that is performing well.  Sometimes if an economy is doing well and inflation is at the central banks upper end of their target the central bank might hike interest rates to make sure that inflation does not overshoot their target.  This hike in interest rates may cause the rate of inflation to slow….that is what disinflation is. It’s not necessarily a bad thing but is something that you should be aware of.

 

Up Next:

So, we are all good on inflation and deflation now.  Next let’s take a look at when inflation gets way too out of control within a specific asset class.  Next up is the fascinating subject of asset bubble.

 

 

 


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