Forex Trading Library

Should We Be Worried About Deflation?

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On the surface, this might seem to be an odd thing to be considering now. Most countries in the world are facing significant inflation problems. Of the “big three”, which we’ll focus on for purposes of answering the title question, the US has the lowest inflation at triple the target rate. The UK is doing the worst, with inflation still in the double digits. That sounds nowhere near close to deflation, right?

But I swear there’s nothing funny in my coffee this morning. The inflation figures that are being thrown around are annual. They compare current prices to what they were 12 months ago. Since then, prices have gone up dramatically, yes. But right now, they could be trending flat, or start to turn downwards, and the annual rate would still be high.

It’s all relative

In fact, to bring inflation down quickly, a drop in prices would help. That is already happening in some goods, particularly energy, as crude prices have come down from what they were ten-ish months ago. It hasn’t spread to the rest of the economy, yet. Monthly CPI change is still coming in positive. But there have been a couple of instances where preliminary monthly reads were negative, but later adjusted.

Monthly inflation fluctuates a bit, which is why everyone focuses on the annual rate. A month or two of negative CPI growth wouldn’t be an issue. But if consumer prices start accumulating enough of a drop, it opens up a whole host of other problems. And here’s the thing: Most experts didn’t expect the current bout of high inflation. So, there is no reason think they are right that there won’t be a bout of deflation at some point.

Why would there be deflation?

Central banks are pulling out all the stops to get inflation under control. The main mechanism is to drain liquidity from markets, by raising the cost to borrow. Meanwhile, people and investors are “spending” their cash as fast as possible to avoid losses from inflation. That spending could be in the form of buying stocks, commodities, or making personal investments. As well as just spending on ever more expensive goods and services. All that means that the amount of disposable income is being kept at a minimum, even as central banks are trying to slow down monetary circulation.

What many people worry is that central banks will have gone too far with their tightening, which could lead to a recession. The way that would happen is precisely through deflation, as it turns out. If disposable income is reduced substantially, then at a certain point demand starts to falter. This loss of demand translates first into higher inventory, then lower prices, as businesses try to move goods. Then those businesses stop buying as much, and the cascade

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