Deflation

In plain words

If a game console costs $500 this year and $480 next year, and the same happens to most things you buy, prices are falling across the board. That is deflation: inflation below zero.

It sounds like great news, and a little of it can be harmless, especially when it comes from better technology, like TVs and computers getting cheaper. But a broad, lasting fall in prices is usually a sign of trouble: people and companies spend less, wages get cut, and debts become harder to repay.

In the US, prices have fallen over a whole year (December to December) in only 11 years since 1914, most of them in the 1920s and 1930s; the last was 1954. Japan lived with gently falling prices for much of the 1990s, 2000s and 2010s.

Example

One level deeper

Deflation can feed itself. If prices are expected to fall, buyers wait; shops cut prices to sell; companies cut wages and jobs; incomes drop and spending falls again. Debts fixed in dollars grow heavier in real terms, so borrowers cut back too.

Central banks fight it by cutting interest rates, but rates cannot go far below zero, so they also buy bonds (quantitative easing). That is one reason most aim for about 2% inflation rather than zero: it leaves a safety margin.

In the Great Depression, US consumer prices fell 23% from December 1929 to December 1933. Since 1960 the deepest 12-month fall was −2.0%, to Jul 2009, after energy prices collapsed in the financial crisis.

US inflation, year by year since 1914

Each bar is the change in consumer prices from one December to the next. Bars below zero are deflation: frequent before the Second World War, almost gone since.

Why it matters

It makes debt heavier, for households, companies and governments, at the worst possible time.

It can freeze spending and investment and deepen a slump, as in the 1930s.

It ties central banks’ hands: with prices falling, even a zero interest rate is a positive real interest rate, so money stays expensive.

A common mistake