Should we be worried about deflation?

As most of the developed world still reels from a year of energy price shocks pushing up costs and leaving many feeling a lot poorer, some observers are now raising the spectre of deflation – a sustained fall in prices.

While this may sound like better news it can set off a chain reaction of negative economic consequences and is as much of a concern for policymakers as soaring prices. This is currently the case in China, which has dipped into deflation after the economy experienced falling consumer prices in July.

So what is deflation, how does it differ from disinflation and what current risk does it pose to the global economy?

Consumers tend to delay purchases when they expect prices to fall further, decreasing overall demand. As demand shrinks businesses face declining revenues, which could lead them to reduce production, resulting in job losses and wage cuts. This vicious cycle can create a deflationary spiral, where falling prices exacerbate economic weakness and even cause a recession.

Japan's experience during the “Lost Decade” in the 1990s is a pertinent example of the deflationary trap. The prolonged period of falling prices and sluggish economic growth showcased the challenges that deflation can present for policymakers and investors.

However, it’s important to distinguish between deflation and disinflation. Deflation occurs when the inflation rate turns negative, indicating a decrease in the average prices of goods and services over a sustained period of time. It is much rarer than disinflation, which is a decrease in the rate of inflation. It means prices are still going up but at a slower rate.

We are currently experiencing this globally as price increases appear to have peaked for now and interest rate rises by the world’s major central banks would seem to be taking effect.

So where do these deflationary pressures emanate from, since consumers are unlikely to have witnessed goods and services getting cheaper just yet? Right now, investors are looking to the US and China, the two largest economies in the world, as a potential source.

While China’s central bank tried to appease deflation concerns in July, efforts to revive its post-COVID economy are ongoing. On 9 August it became the first G20 country since 2021 to report year-on-year decline in consumer prices, Reuters reports.

With growth faltering in China, some commentators expect a devaluation of the currency to bolster exports. As China remains the world’s manufacturing hub that could mean cheaper goods are coming your way.

While this news is likely to stoke concerns about the problem being exported, other economic signs such as Brazil cutting interest rates at the start of August, could mean inflation has peaked or is even in reverse, Reuters says.

In the US, investors and policymakers have been closely monitoring the situation at home, as the country’s producer prices barely rose in June after falling in May and the annual increase in producer inflation was the smallest in nearly three years. The inflation rate in the US has also tumbled. The dollar fell as a result of China’s deflation news and expectation of monetary stimulus from its government.

Morgan Stanley's chief stock strategist Mike Wilson warned in July that disinflation is about to turn into deflation in some sectors of the US economy – a major headwind for corporate earnings.

But he says his view is a minority one and, for now, there are no widespread concerns about global deflation. In its latest updated forecasts, the International Monetary Fund has actually revised up its forecast for global inflation in 2024 to 5.2%, which is still more than twice most advanced economy central banks’ inflation target of around 2%.

Economists will be sharing their views on the global economic picture in the World Economic Forum’s next Chief Economist Outlook report launching at its Sustainable Development Impact Meeting in September 2023.