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Wednesday, 27 May 2015

An Introduction to Deflation

For the first time in fifty years, the UK has just recorded a quarterly fall in prices. The global average figure is the result of price falls in just a few sectors, notably food and air travel. Nonetheless, even a hint of Deflation is significant. It affects behaviour.

If you are sitting on cash, you may be tempted to hold on to it because prices may fall further. So you postpone the planned replacement of your car or sofa.

If you are sitting on stock, especially if you haven’t yet paid for it, then you get a bit nervous and want to sell it soon before prices fall. In fact, you are tempted to cut prices a bit to encourage buyers. But buyers , when they see your prices fall, have their beliefs confirmed that prices are going to fall and may hold out a bit longer. So your stock remains in the warehouse and you cut back on new orders.

In addition, if you are in the UK, you can see the £ getting stronger against the €uro, and you know that means that the price of imports is going to fall and many  imported goods are going to start getting cheaper in the shops.

As a combined result, UK manufacturers find themselves with falling orders and put some workers onto short time working, reducing the incomes they have available to spend. Now those workers decide they can’t afford that new sofa, even though sofas are cheaper than they were three months ago.

The most ruthless players in the market, whether consumers or traders, will generalise their experience and decide: Hold on to cash, sell out stock, don’t buy anything except maybe houses (the supply of which is fixed and unaffected by falling import prices)  – just Wait.

This is how a deflationary spiral begins, a spiral which reduces the overall level of economic activity, reduces spending power and increases unemployment. In contrast, when there is a bit of inflation around, it helps keep the economy moving – people don’t delay spending, sellers get a bit of extra profit out of the fact that prices go up between the time they buy and the time they sell – and they place new orders with suppliers, confident that all is well.

The Bank of England should be thinking hard how it can put a bit of inflation back into the economy.

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