Why Central Banks Like Inflation More Than Deflation

n a world that's panicked about inflation, it wouldn't be a surprise if you saw deflation as a welcome alternative. However, a decrease in prices isn't all rainbows and butterflies. It can also have severely negative consequences for the economy.  

What is Deflation?

Deflation is a decline in the general price levels of goods and services in the economy. This means that prices are declining overall, which would show as a negative number in inflation data such as the Consumer Price Index.

If prices in the economy are declining, that means the currency's value in the economy strengthens, increasing purchasing power, real incomes, and wealth that could lead to more spending and help boost economic growth.

So, if deflation can help economic growth, why do the central banks prefer inflation instead?

The Problem With Deflation

Although I mentioned it could lead to an increase in economic growth, it could have the opposite effect.

For example, when goods and services prices decline, consumers may delay purchases as they hope they will become cheaper in the future, contributing to lower economic growth.

Another primary reason for avoiding deflation is that it increases the real value of debt and could make it harder to repay. For example, if a business takes out a loan to expand and prices continue to fall, it may need to make more money to repay the loan. That increases the risk of defaults and could make getting a loan in the first place much more difficult.

Following that example, deflation also leads to lower profits for businesses as they need to lower prices to remain competitive. This would likely result in less expansion and hiring. That could suppress wages which would lead to lower consumer spending.

Eventually, businesses may be forced to lay off workers to maintain margins, leading to increased unemployment.  

This could lead to lower consumer spending, which leads to lower profits and more job losses. As you can see, it has the potential to become a vicious cycle.

However, a study in 2015 by the BIS found that the link between economic growth and deflation is actually quite weak, with the Great Depression being the main exception.

The study suggests the main problems from deflation come from a sharp fall in asset prices, particularly housing prices, which erodes wealth and can lead to banking distress, not so much the falling prices of goods and services.

The Causes of Deflation

Deflation is often associated with a decline in demand, pushing down prices, incomes and output. While this can be correct, deflation can also result from oversupply.

The same study from BIS gave examples of “improvements in productivity, greater competition in the goods market, or cheaper and more abundant inputs, such as labour or intermediate goods like oil."

"Supply-driven deflations depress prices while raising incomes and output.” So in this scenario, deflation may have positive effects on economic growth.

How Might a Central Bank Respond to Deflation

However, the threat of another depression-era deflation is a genuine concern, as debt to GDP levels tends to be very high.

Due to this, the central bank targets a positive inflation rate, usually around the 2% mark for developed countries. If the economy went into deflation, the central bank would likely make decisions stimulating economic growth.

The first decision a central bank might take is lowering interest rates to encourage more borrowing and spending. However, as we mentioned earlier, if the real value of debt is increasing, consumers and businesses may find it difficult to take on more debt.

That means the central bank could be forced to take more extreme actions. One could be quantitative easing to increase the money supply, which encourages banks to lend more and further lowers rates to encourage more borrowing.

Overall, maintaining a low and stable inflation rate is an important goal for central banks to avoid the risks that come with deflation.

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