what is deflationDuring the last half of the 20th century, financial managers were trained to worry almost exclusively about inflation and the threats of constantly rising prices. In the 21st century, senior finance managers suddenly have to face inflation’s opposite: deflation.

Today, companies and governments are faced with figuring out how to invest, raise capital, lend and borrow, craft monetary policy, make reliable projections and avoid disaster in a time of continually falling prices.

Deflation and fears of it have turned economics and financial management upside down.

“The normal tools of monetary policy don’t work very well in this black hole,” widely followed economics expert David Wessel said in a recent interview, commenting on the failure of governments across the globe to reverse the advancing deflationary trends.

Succeeding in deflationary times requires different strategies than the more familiar environment of inflation. To cite just one example, borrowing money is much riskier, most economists agree, because the cost of debt does not fall as other prices do, making debt payments increasingly expensive if deflation takes hold. For a company facing falling prices, debt can be painful or even terminal.

Ultimately, with very low inflation or real deflation, it is simply more difficult to produce the kinds of rising corporate profits that have been a standard feature of our business history.

No more “automatic” profit growth

“One of the challenges of very low inflation is you don’t get very much automatic revenue growth, and that puts a lot of pressure on companies,” explained Wessel, who directs the Hutchins Center on Fiscal & Monetary Policy in Washington, D.C.

Deflation is spreading in Asia and, more recently, Europe. The U.S. is experiencing ultra-low inflation  —  far below the Federal Reserve’s target. For the first time in roughly a century, prices and wages can and do go in more than one direction. Deflation is as likely as inflation.

The possibility of global deflation is going to persist  —  and so will the need for financial managers to know how to deal with it.

Deflation is generally defined as a year or more of falling prices and wages. Most economists measure inflation or its opposite using two indicators in particular: wages, as measured by the employment cost index, and what people spend on goods and services, measured by the personal consumption expenditures price index. Both have barely budged in years.

“Wages have been going up a little, but you’d need a microscope to see it,” Wessel comments.

The Fed admits it’s worried by “weak inflation” and continues to delay plans to raise its interest rates, which still hover close to zero a full eight years after the Great Recession. Central banks in Asia and Europe are experimenting with “negative interest rates”  —  the strangest new addition to the anti-deflation toolkit. Negative rates raise the odd specter of companies and individuals being paid to borrow money and charged to keep cash in a bank.

Should we really fear deflation?

Since lower prices do not inspire nightmares for most consumers, many wonder why they should fear deflation. The reasons, it turns out, are legion.

“Deflation does more macroeconomic damage” than inflation, wrote J. Bradford DeLong in a forward-looking white paper in 1999, as modern deflation fears were first appearing.

Along with many economists, DeLong, formerly a senior Treasury Department official in Bill Clinton’s administration, sees the damage beginning with “large transfers of wealth from debtors to creditors if prices fall far.” The rising real cost of debt will, in turn, reduce investments and depress the demand for goods and services, he wrote.

Deflation boosts unemployment, economists agree, especially since wages generally do not fall as fast as prices. The gap between slowly dropping salary costs and rapidly falling revenue forces companies to lay off employees to shrink expenses.

Perhaps most important, if persistent deflation convinces people to expect falling prices, they tend to postpone purchases because they believe everything will be cheaper tomorrow. This promotes a dismal downward economic spiral.

Deflation is nothing new, of course. It was first discussed in the late 1500s, according to the Federal Reserve Bank of Richmond. But the Great Depression of 1929 was the last real occurrence of deflation in the U.S., and the workings of deflation have been literally lost in history.

Today, three of the four biggest economies on earth  —  Japan, China and the Eurozone  —  are suffering from deflationary pressures, while the U.S. is trying to avoid it. The real possibility of global deflation is going to persist, and so will the need for financial managers to know how to deal with it.

 

KNOWLEDGE CENTER

Should We Fear Deflation?: UC Berkeley Economics Professor Brad DeLong’s early deflation warning, which helped frame the U.S. conversation.

5 Reasons to Worry About Deflation: Wall Street Journal contributing columnist David Wessel’s deflation-issue breakdown.

The Hutchins Center Explains: Negative Interest Rates: Also from Wessel, a solid overview of negative-territory interest rate repercussions.

A World Stumped by Stubbornly Low Inflation: The recent widely read article by Lawrence Summers, the Harvard economist and former Treasury secretary.

 

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Deflation: Managing in a Financial Black Hole
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Deflation: Managing in a Financial Black Hole
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During the last half of the 20th century, financial managers were trained to worry almost exclusively about inflation and the threats of constantly rising prices. In the 21st century, senior finance managers suddenly have to face inflation’s opposite: deflation.
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