The ogre stalking Europe’s weak economies isn’t the one people have learned to fear. The monster isn’t inflation but its opposite: falling prices. Its name is deflation and it appears friendly. Why be afraid when the cash in people’s wallets buys more fuel and televisions, not less? Because when deflation grabs hold, companies and consumers stop spending. It strangles borrowers because their debts get harder to repay — a menace for countries struggling to exit the worst recession in a generation. In this fairy tale, inflation comes dressed in shining armor as policy makers debate how to create just enough of it to keep deflation at bay.

Six years since the 2008 financial crisis turned the global economy upside down, deflation threatens to drag out the turmoil in Europe. The continent’s economies have failed to recover the momentum needed to stimulate slow-but-steady price increases, which most central bankers consider desirable. Consumer prices in the euro area fell for the first time in more than five years in December. The slide in oil is adding to the deflationary pull and prices are expected to drop further in 2015. About a third of the goods that Europeans commonly buy are declining in price, including clothes and carpets, according to Jefferies International. In Japan, inflation only began showing signs of life in 2013 as the central bank targeted a 2 percent price gain in an all-out bet to shake off more than a decade of deflation and stagnation. Japan fell back into recession in 2014 and inflation risks slipping anew after an increase in the consumption tax.

Central bankers find it easier to beat inflation than deflation. When prices rise too fast, policy makers raise interest rates, then pull back when the economy slows. It’s harder to calibrate the right dose of medicine to ward off deflation. Interest rates in most large countries are still near zero, and the European Central Bank even cut a key rate into negative territory in June 2014. In Greece, deflation may be a price worth paying to make the country competitive again after years of living beyond its means. Bond-buying programs like those that helped revive the U.S. and Japan have also had dangerous side effects. They’ve sent money flowing into stocks and property, boosting the prices of assets rather than products, raising concern that too much easing was creating bubbles. Even so, the ECB has started buying private-sector assets to boost prices, and the slide is bolstering the case for a plan to buy government bonds to add more stimulus. Even when the threat of deflation seems small, history tells us that it’s a huge risk.

David Fuller's view

The opening paragraph above sets the tone for this topic which is often misunderstood by the public at large.  In an ideal world, which seldom exists for long, we would all be free of debt and have sufficient wealth to live comfortably in an era of generally stable prices.  However, it is often harder for a young and even ambitious person of modest means to accumulate wealth in a deflationary environment, especially a destructive deflation of lower growth, profits and prices.  Japan has struggled with this environment for approximately two and a half decades, and Europe is now feeling the same pinch. 

The main reason why central banks fear deflation today is because many economies carry too much debt.  Deflation increases the real value of debt and can therefore prolong recessions.  I am uncomfortable with the first sentence of the third paragraph above:

“Central bankers find it easier to beat inflation than deflation.”

Try telling that to a German who knows about 1919-1923, or a contemporary Zimbabwean, Venezuelan, Iranian, Argentinean, or possibly a Russian over the next few years.  In the current era of freely floating currencies, inflation has arguably been a bigger and more frequent problem than deflation.  In my own research business during the 1970s and even through the 1980s and 90s when inflation was less of a problem, colleagues expected annual salary increases in excess of inflation, regardless of profits. 

Europe aside, my hunch is that investors are overly concerned about global deflation today, largely because of slow GDP growth and falling commodity prices, not least crude oil.  Yes, demand from the biggest consumer of resources five or six years ago – China, has slowed as officials attempt to upgrade their economy.  Thereafter, technology is an underappreciated factor in the supply glut, from increasing oil production thanks to easier detection, hydraulic fracturing and horizontal drilling, to more efficient mining, and even biotechnology such as Monsanto’s genetically modified seeds.  Consider also the increased factory mechanisation of so many finished products.

These are improvements, at least in terms of being able to increase the production and quality of goods, often for less labour or cost.  The ability to improve production is a pro-growth positive aspect of the accelerating rate of technological innovation.  Higher production and lower prices for more goods is positive deflation, which ultimately underpins long-term GDP growth.

In conclusion, I think we will see more positive than negative deflation over the next five years and probably many more.  Additionally, we will also see inflation increase somewhat.  This environment will favour quality shares much more than government bonds, which will obviously not remain near record lows for recovering economies.