deflation, economy, interest rate hike An image of a purple balloon floating in a blue sky with white clouds in the background. An image of a purple balloon floating in a blue sky with white clouds in the background. An image of a purple balloon floating in a blue sky with white clouds in the background. An image of a purple balloon floating in a blue sky with white clouds in the background.
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Understand Your Finances

Why deflation isn't always bad. Seriously.

In the current economic environment, falling prices could mean more growth.

The Federal Reserve is sticking to its plan to raise interest rates despite inflation falling persistently short of the official 2 percent target. Some critics are calling for the Fed to pause before hiking rates any further, arguing that the policy is counterproductive because higher interest rates naturally weaken inflationary pressure.

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Instead, the Federal Open Market Committee believes that weak inflation is "transitory" and doesn't require a policy change. The next interest rate hike is widely expected to come in December, and the committee's June meeting minutes indicate that most members anticipate inflation will move toward 2 percent, even as interest rates continue to climb.

The Fed's stance reinforces the distinction between the two types of deflationary pressure. Prices can fall because of weakening aggregate demand, a sign of economic distress. Or they can fall as the result of a supply-side windfall, which will ultimately support faster growth.

Textbook deflation

The typical case of “bad" deflation accompanies recessions, when prices fall because of a drop in overall demand. An economic shock—such as a plunging stock market or collapsing real estate values—can cause businesses and consumers to cut back on spending. As a result, demand falls, causing prices to drop as retailers offer steep discounts in the hope of attracting buyers.

Bad deflation typically leads to widespread layoffs. Businesses that are no longer profitable are forced to cut payrolls, and the workforce shrinks until the economy's production aligns with the reduced level of aggregate demand.

This scenario played out during the last recession. Between July 2008 and July 2009, chained personal consumption expenditures went from growing 4.19 percent year over year to contracting 1.18 percent. Over the same period, the labor market shed nearly 7 million jobs and GDP contracted by more than $450 billion.

When aggregate demand falters, the Fed can use its power over interest rates to lower borrowing costs and encourage spending. During particularly sharp downturns, the federal government can even directly spur demand through fiscal stimulus legislation. But today's weak inflation likely requires neither response, as it appears to be driven by different factors.

Benign deflation

Fortunately, the current bout of soft inflation doesn't appear to signal deteriorating demand. The labor market is growing stronger, with the economy adding an average of 180,000 new jobs every month in 2017. The aggregate number of hours worked rose at a 2.3 percent annual pace in the first half of 2017, accelerating from 1.3 percent growth in 2016. Layoffs are at historically low levels, a sign that businesses aren't seeing a shortage of customers.

Instead, today's weak inflation is likely the result of cheap energy and technological advances that have made consumer goods less expensive to produce. The global oil glut caused inflation to fall near zero in 2015, but rather than reduce aggregate demand, low fuel prices freed up money for consumers to spend elsewhere.

The most recent breakdown of consumer expenditures shows that price moderation is being driven, in part, by lower prices for communication services, like mobile phone plans, which have fallen 4.66 percent annualized since the start of 2017. This type of supply-side deflationary pressure promotes growth as spending moves to other sectors of the economy.

Eventually, aggregate demand will catch up with supply and inflationary pressure will build. Keeping interest rate normalization on track will likely prolong the business cycle's peak by gradually moving rates toward historically normal levels as the economy approaches operating at full capacity.

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