Personal Finance Apr 01, 2024 07:36 AM EDT

Is Deflation Coming? How to Prepare Your Finances Now

By April Fowell

The fundamental reason why the economy is making many Americans unhappy is because prices seem too high.

Although the rate of increase in average prices may have slowed down, it is still much higher than it was three years ago. Most of them are still going upward.

Is Deflation Coming? How to Prepare Your Finances Now

Although the rate of increase in average prices may have slowed down, it is still much higher than it was three years ago. Most of them are still going upward.
(Photo : by Stephen Chernin/Getty Images)

Before inflation started to pick up speed in February 2021, the average price of a 2-liter bottle of Coke in American stores was $1.67. After three years, the price of that bottle has increased by 35% to $2.25.

The average cost of a secondhand automobile also skyrocketed, rising from around $23,000 in February 2021 to $31,000 in April 2022. By the previous month, the mean had dropped to $26,752. Still, that is a 16% increase from February 2021.

Wouldn't it be wonderful if prices truly decreased-a situation known to economists as deflation?

In any case, prices are now increasing more slowly, a phenomenon known as disinflation. For instance, the government reported on Friday that a major price index increased by 0.3% in February rather than 0.4% in January. Additionally, prices were up 2.5% from a year ago, a significant decrease from a peak of 7.1% in the middle of 2022.

However, the public's dissatisfaction with costs is so great that it is threatening President Joe Biden's reelection campaign. These little adjustments are scarcely enough to appease the people.

What You Need to Know About Deflation

However, a lot of economists advise customers to be cautious about their wishes. A decline in pricing across the board would be unfavorable.

A significant and persistent decline in prices throughout the economy is known as deflation. Periodic monthly decreases in consumer prices are not significant. Since the 1930s Great Depression, there hasn't been a true deflation in the US.

Deflation has occurred in Japan much more recently. After decades of declining prices, which started in the early 1990s with the collapse of its property and financial markets, it is just now beginning to recover.

The Spanish central bank, Banco de España, highlights on its website that while lower prices may initially appear favorable, deflation can pose significant risks to the economy. This is primarily due to the tendency of falling prices to deter consumer spending.

When prices are decreasing, consumers may delay purchases in anticipation of even lower prices in the future, whether for items like cars, furniture, appliances, or vacations. However, this behavior can have detrimental effects on the economy's overall health, as consumer spending plays a pivotal role in driving economic activity. In the United States, household spending constitutes approximately 70% of the total economy. Should consumers collectively withhold their spending in anticipation of further price drops, businesses would face heightened pressure to reduce prices further in order to stimulate sales.

Employers may have to reduce wages or lay off waves of workers in the meantime, or both. Naturally, those without jobs are even less likely to spend, thus prices will probably continue to decline. This might lead to a "deflationary spiral" of price reductions, job losses, price reductions, and job losses. And so forth. There could be another recession after this one.

The Bank of Japan used negative interest rates in 2016 and the Federal Reserve held U.S. interest rates close to zero for seven years in a row during and after the Great Recession of 2007-2009 in order to avert that exact kind of economic ugliness.

Deflation also has an unpleasant side impact for borrowers, increasing the cost of their inflation-adjusted loans.

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Deflation Benefits

It is undoubtedly true that while costs are declining, Americans can stretch their wages farther. As long as people continued to work, households would undoubtedly find it easier to pay for groceries and their daily journeys if food or petrol prices fell.

In fact, several economists contest the idea that deflation represents a major danger to the economy. After analyzing 140 years of deflationary episodes in 38 economies, researchers at the Bank for International Settlements, a forum for the world's central banks, came to the following conclusion in 2015: the relationship between declining prices and economic growth "is weak and derives mostly from the Great Depression."

The exception, however, was rather significant: from 1929 and 1933, the United States' economic production fell by a third, prices fell by a quarter, and the jobless rate skyrocketed from 3% to a devastating 25%.

According to the bank's economists, a freefall in asset values, such as stocks, bonds, and real estate, poses a greater economic danger than declining commodity and service prices. Banks that own failing assets or have extended loans to faltering real estate developers and homeowners may also be brought down by those falling assets.

The credit that is the lifeblood of the entire economy may potentially be shut off by the damaged institutions. The most likely outcome? A severe economic downturn.

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