Understanding Deflation: Insights for New Zealanders
Blog

Understanding Deflation: Insights for New Zealanders

Finance
|
3.2.21
|
Joseph Darby
Inflation has an evil and less-known cousin, deflation

Deflation, a term often heard in economic discussions, can have significant implications for an economy. While inflation, the rise in prices over time, is commonly discussed, deflation — the decrease in the general price level of goods and services — is equally crucial.

While everyone has been focussed lately on inflation, it could be in years to come deflation is the main concern. In fact, before the measures taken to combat the pandemic, including lockdowns and quantitative easing (including money printing at a vast scale) in New Zealand and many countries it was deflation, not inflation, that was concerning many economists and the central bank.

Now it looks as if the war against inflation is all but over, and there is a chance deflation might become the new public enemy number one. So, let’s take a closer look at deflation, its causes, effects, and what it might mean for New Zealand.

Deflation Defined

Deflation occurs when the general price levels in an economy decline over a period. This phenomenon is the opposite of inflation, where prices increase. Deflation can be measured using various price indices, such as the Consumer Price Index (CPI) or the Producer Price Index (PPI). When these show a sustained downward trend, it indicates deflation.

Causes of Deflation

Deflation can result from several sources, or combination of them:

  1. Decrease in Total Demand: When consumers and businesses reduce their spending, overall demand for goods and services drops. This decline in demand can lead to lower prices.
  2. Increase in Total Supply: An increase in the supply of goods and services, without a corresponding increase in demand, can also cause prices to fall.
  3. Technological Advancements: Innovations can lead to higher productivity and lower production costs, resulting in cheaper goods and services. We should now all understand technology is advancing quicker than ever!
  4. Monetary Policy: Tight monetary policy, such as higher interest rates or reduced money supply, can reduce spending and investment, contributing to deflation.

Effects of Deflation

While lower prices might seem beneficial for consumers, deflation can have several adverse effects on the economy:

  1. Reduced Consumer Spending: When prices fall, consumers may delay purchases, expecting prices to drop further. This can lead to a decrease in overall economic activity.
  2. Increased Real Debt Burden: Deflation increases the real value of debt. Borrowers, including households and businesses, may find it harder to repay their loans, leading to financial distress.
  3. Lower Business Profits: Falling prices can erode business profits, making it challenging for companies to maintain operations and invest in growth.
  4. Unemployment: As businesses cut costs to cope with lower profits, they may reduce their workforce, leading to higher unemployment rates.

To sum up, consider this from Liam Dann, the NZ Herald Business Editor

“The biggest issue is that deflation, like inflation, tends to spiral and become self-perpetuating.
Falling prices tend to discourage consumers from spending. People think, why buy now if you can purchase what you want – cars, furniture, appliances, vacations – at a lower price later?
But as prices fall, business margins are squeezed, production falls and businesses contract. Jobs are lost and new jobs are not created. Wages fall and people are poorer so they can afford to spend even less.
Without growth and momentum, opportunity is removed from the economy ... and opportunity is one of capitalism’s most powerful drivers.”

The Current Economic Concern: Inflation

In today's global economic environment, the primary concern for many is inflation rather than deflation. The COVID-19 pandemic, supply chain disruptions, and significant fiscal stimulus measures due to the pandemic led to rising prices worldwide. New Zealand was no exception. The Reserve Bank of New Zealand (RBNZ) has been monitoring inflation closely, with recent data showing a steady decrease in the CPI after a spike in the post-Covid years.

Why is Inflation the Main Focus?

  1. Pandemic Effects: The pandemic caused supply chain disruptions and productivity issues as people couldn’t leave home, leading to higher costs for goods and services. These higher costs were often passed on to consumers, contributing to inflation.
  2. Stimulus: Governments worldwide, including New Zealand's, implemented extensive stimulus measures to support economies. In New Zealand this was especially pronounced as our border was closed. While this stimulus helped prevent economic collapse, it also increased demand, contributing to inflationary pressures.

While inflation remains the focus, understanding deflation remains essential, as economic conditions are changing as inflation falls rapidly. It could be deflationary pressures can emerge in the future.

Historical Instances of Deflation in New Zealand

Historically, New Zealand has experienced periods of deflation, though they have been relatively rare compared to inflationary episodes. For instance, during the Great Depression in the 1930s, New Zealand, faced significant deflationary pressures. More recently, the global financial crisis of 2008-2009 brought about deflationary fears, although New Zealand managed to avoid prolonged deflation.

Current Economic Context

A few regions, including New Zealand, Europe, China, and many other countries, are experiencing weak economies. However, the United States stands out as a notable exception.

Right now, Europe and China are battling deflationary forces. The Financial Times has run articles on deflationary risk for both China and Europe. “Avoiding a fall back into the pre-Covid world [of inflation below 2%] will be one of the ECB’s biggest challenges,” Jens Eisenschmidt, chief Europe economist at Morgan Stanley told the Financial Times.

Deflation in Japan, a Case Study

Japan has experienced prolonged deflation, starting in the late 1990s following the burst of its asset bubble and subsequent financial crisis. Demographics haven’t helped either: Japan is an ageing society, and the Japanese are reluctant to let in large numbers of migrants to help offset low birth rates. This all led to a sustained decline in prices: deflation. The Bank of Japan (BoJ) introduced various measures to combat deflation and stimulate economic growth.

Deflation led to lower returns on Japanese investments, as both asset prices and interest rates remained low. Investors faced challenges in finding profitable opportunities and often turned to safer assets like government bonds.

For individuals, deflation meant lower prices but also stagnant wages and increased real debt burden. This made financial management challenging, as purchasing power did not keep up with living costs.

Recent years have shown positive results due to the BoJ’s aggressive monetary policies, fiscal reforms, and improved corporate dynamism, helping Japan overcome deflation.

Implications for New Zealanders

Deflation could have far-reaching implications for your personal finances. Here are some key considerations:

Banking and Lending

In a deflationary environment, the real value of loans increases, posing challenges for borrowers. Banks may face higher default rates as borrowers struggle to meet their repayment obligations.

Investments

Deflation can affect investment strategies. Traditional asset classes, such as stocks and real estate, may underperform in a deflationary environment. Investors might seek safer assets, such as government bonds or gold, which might retain value during economic downturns.

Savings

For savers, deflation can be a double-edged sword. While the purchasing power of saved money increases, low-interest rates mean that returns on savings accounts and fixed-income investments may be minimal, or even negative.

How to Navigate Deflation

If there is a realistic chance of deflation, understanding how to navigate it could be crucial for New Zealand consumers:

  1. Smart Spending: Consumers should adopt a smart spending approach, prioritising essential purchases and taking advantage of lower prices for non-essential goods.
  2. Debt Management: Reducing high-interest debt should be a priority. In a deflationary environment, the real burden of debt increases, so paying down debt can provide financial stability.
  3. Savings and Investments: Diversifying savings and investments can help protect against deflationary impacts. Consumers could consider a mix of assets to balance risk and return.

Policy Responses to Deflation

Policymakers play a crucial role in addressing deflation, it could be The Reserve Bank of New Zealand (RBNZ) and the government can implement various measures to mitigate deflationary pressures:

  1. Monetary Easing: Lowering interest rates and increasing the money supply can encourage borrowing and spending, helping to boost demand.
  2. Fiscal Stimulus: Government spending on infrastructure projects, social programs, and other initiatives can stimulate economic activity and counteract deflation.
  3. Targeted Support: Providing targeted support to sectors most affected by deflation, such as small businesses and households, can help stabilise the economy.

The Bottom Line: Deflation

Deflation, though less discussed than inflation, is a critical economic issue with far-reaching implications.

By staying informed and proactive, you can mitigate the challenges posed by deflation, should it arise as an issue in the near, or distant, future.

You may also like: