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Inflation and deflation: The double-edged sword in economic dynamics

Hei Tung Sam
Hei Tung Sam • 8 min read
Inflation and deflation: The double-edged sword in economic dynamics
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In a world where every tick of the economic clock swings between growth and recession, inflation and deflation stand as the dual forces shaping our financial landscape. 

These two economic phenomena, often mentioned in news headlines and everyday conversations, have profound impact on our daily lives and the global economy. But what exactly are inflation and deflation, and why do they matter so much? 

In this article, we will delve into the concepts of inflation and deflation, their implications and impact on our daily lives. We will also review historical lessons to avert such economic phenomena in the future.

Inflation, core inflation, consumer price index and deflation are terms frequently mentioned by mainstream media, analysts and even cab drivers as a conversation-starter, as they talk about the increase in prices of their morning coffee and essential daily goods such as milk, eggs and rice. News outlets have highlighted these economic trends with headlines such Channel News Asia’s “Singapore’s core inflation rises to 5.5% in January, highest since November 2008”. Meanwhile, China is currently grappling with deflation.

With both inflation and deflation manifesting globally, let us examine their effects on economies (in terms of gross domestic product or GDP) and the repercussions on citizens’ spending habits.

Inflation and GDP
Inflation is defined as a measure of how much more expensive a set of goods and services has become over a period of time. The general public perceives inflation negatively as it is commonly seen as wealth’s adversary, diluting the value of money and savings over time. However, economists and central banks around the world either have a mandate to keep long-term inflation at approximately 2%, as does the Federal Reserve (the central bank of the US, commonly referred to as the Fed), or aim to maintain controlled inflation to promote economic growth, like the Monetary Authority of Singapore (MAS, the central bank of Singapore).

See also: Remedying the symptoms of ‘money dysmorphia’

When news reports announce a rise in inflation, it raises the question: how exactly is inflation measured? To measure inflation that impacts the average household, it is important to compile a basket of goods and services that the average household typically consumes over a period of time. This basket includes items related to housing and utilities, food, transport and other essential needs.

The Consumer Price Index (CPI) serves as a measure of the overall change in consumer prices, based on this basket of goods and services across a certain period. The selection within the CPI basket is static and undergoes revision only once every five years, to account for shifts in household purchasing habits. Hence, individual experiences of price fluctuations might vary from the official inflation rate, as the diverse components within the CPI basket may increase or decrease in prices at differing rates. Inflation levels are determined by comparing the price changes of the CPI basket items over time. Table 1 shows an example, assuming an average household’s consumption of items A to D, each item once. 

See also: One dollar at a time: The potential of fractional shares

Inflation encourages households to increase their current consumption, as a dollar today can buy more than tomorrow. Furthermore, inflation plays a significant role in influencing a nation’s nominal GDP. Nominal GDP is defined as the market value, that year’s prices, of all final goods and services produced within a country in a specified period.

Inflation and deflation reflect the interplay between the general supply in the economy and the overall demand. During the 2020 pandemic, both the aggregate supply and demand for goods decreased, as suppliers had to halt production, and lockdown measures restricted household consumption, as depicted in Chart 1.

Chart 2 illustrates the dual shocks to demand and supply during the 2020 Covid pandemic and the subsequent rebound in demand in 2021, while supply continued to lag. In 2020, during the peak of the Covid crisis, inflation was subdued below 2%, as both aggregate demand and supply diminished. However, in 2021, as aggregate demand began to surge due to pent-up demand and the gradual lifting of Covid lockdowns, but with aggregate supply still lagging, inflation escalated to 9.1% in June 2022.

A supply shock due to supply chain bottlenecks and backlogs of shipping containers across the world is not something that can be solved quickly by lowering interest rates, and increasing fiscal stimulus. It requires sufficient investments, labour force participation and most importantly, time. With a target long-term inflation of approximately 2%, economists and analysts agree that low and controlled inflation fosters economic growth and maximises employment, while also managing the inflation expectations of both suppliers and buyers.

The anticipation of future inflation acts as a self-fulfilling prophecy: when consumers, businesses, investors and other participants anticipate high inflation in the near future, they tend to increase prices now or escalate their purchases, thereby bringing about the anticipated inflation. By setting a target of approximately 2% for long-term inflation, central banks play a crucial role in managing inflation expectations, enabling market participants to adjust their inflation forecasts accordingly.

For more stories about where money flows, click here for Capital Section

Deflation in China
Conversely, deflation signifies the average decrease in price levels of goods and services over time. It enhances households’ purchasing power, as a dollar tomorrow can buy more goods and services compared to a dollar today. At first glance, households might perceive deflation as preferable to inflation, as it allows them to stretch their purchasing power further. However, prolonged deflation can have significant adverse effects on the economy and overall purchasing behaviour, underscoring its complex nature as a double-edged sword in economic dynamics.

As China’s Producer Price Index, which measures inflation from the producers’ perspective, dipped into the deflationary territory in late 2022, China’s CPI followed suit, entering deflation in July 2023. While much of the world is still grappling with inflation, China is starting to experience deflation. This is mainly due to domestic demand within the country that has fallen short.

With average price levels on the decline, households may anticipate further price drops and consequently delay their purchasing decisions. This postponement in consumption leads to a decrease in aggregate demand for goods and services, prompting suppliers to reduce production, which in turn results in higher unemployment rates and diminished investments. Such is the vicious cycle of deflation, which inflicts long-lasting damage on both the economy and investor sentiment.

The most damaging aspect of deflation is the decrease in aggregate supply, which lowers overall economic output. Monetary policies from central banks and fiscal stimuli from governments typically influence aggregate demand more than aggregate supply. Changes in monetary policy take time to affect the overall economic output as constructing factories and enhancing efficiency are capital-intensive activities that require careful planning and time.

For instance, in 2021, central banks globally reduced interest rates to nearly 0% and initiated extensive quantitative easing programmes with the aim of revitalising the economy. While aggregate demand experienced a resurgence, the response from aggregate supply was delayed, slowly recovering due to global supply chain issues and the effects of lockdowns. 

Japan experienced a prolonged period of deflation during Japan’s “Lost Decade” in the 1990s. This era exemplifies the severe and persistent effects of deflation, which entrenched itself deeply within the economy, resulting in nominal GDP falling below real GDP. Japan’s GDP growth remained stagnant, while similar and other regional economies experienced significant growth. It took Japan years of aggressive monetary policies, alongside tax and spending reforms, to eventually reach an average inflation rate of 2% in recent years. Moreover, the Japanese yen has faced significant depreciation, losing value and causing import prices to surge, with the yen reaching a 30-year low.

In response to its deflationary measures, China’s central bank, the People’s Bank of China, has implemented monetary policies such as lowering interest rates, and the government has been ramping up fiscal stimulus through bond offerings to boost funding in critical sectors such as food and energy. Recent macroeconomic data from China suggests a potential end to deflation and signs of economic recovery, with China officials forecasting a GDP growth rate of 5% in 2024.  

In conclusion, historical periods of long-term deflation have led to economic downturns and increased unemployment across various countries. From the US’s “Great Depression” to Japan’s “Lost Decade”, central banks have learned the importance of avoiding deflation at all costs. While inflation is often viewed negatively for eroding wealth, a low and controlled inflation rate of approximately 2% can stabilise future inflation expectations and promote a healthy business and financial environment, where business decisions are not adversely impacted by inflation. Depending on the cause, whether it’s a shock to aggregate demand or aggregate supply, different policies from both central banks and governments are required to address inflation effectively.  

Hei Tung Sam is senior dealer, contract for differences, at PhillipCapital

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