Inflation, deflation and interest rates

Deflation, not inflation, is the creature lurking around the corner. defines inflation as "the rate at which the general level of prices for goods and services is rising, and, subsequently, purchasing power is falling."

Most people assume inflation is a bad thing. Who would want to pay more for something in the future?

The opposite of inflation is deflation. It is a general decline in prices often caused by a reduction of the money supply or credit.

Most people think deflation is desirable. The longer you wait, the cheaper prices get and the more you can buy with your money.

But deflation can be devastating to the overall economy. That's because in a deflationary environment there is less incentive to spend now, when things are more expensive. So people delay their shopping trips. And that is what can hurt because consumer purchases are a key driver for the economy.

As sales slow down, companies make less profit, which puts pressure on the bottom line. As a reaction, companies cut costs and some, especially larger ones, become easy targets.

Labour is often first on the list. Companies tend to lay off employees. And unemployed people aren't likely to go out shopping. That means there are fewer consumers for companies to sell to and the downward sales trends are amplified.

This general slowdown also affects governments, which is important because they are called upon to prevent the economy from calamity. But they need to be financially healthy to do so. To them, the slowdown means less corporate income tax revenue. Fewer employed people also results in less personal income tax revenue. And that hurts countries because, for most countries, personal income tax is by far their largest source of revenue. A government's employment insurance payouts also rise in such an environment.

The negative effects of the shrinking economy also put pressure on the banking system. Less business and personal financial activity means lower profits as the number of banking transactions declines. Corporate and personal loans outstanding on lenders' books are less likely to be fully recoverable from clients experiencing a lowering of profits or loss of jobs. In this environment, banks also get wary of additional lending for business startups and invest in other things, thus putting further downward pressure on business growth and spending.

This vicious downward spiral spares no one and it is very difficult to stop once it starts. Need an example? Look at the Great Depression of the 1930s. Most business activity ground to a halt. Very few jobs were available during this time. Just read John Steinbeck's The Grapes of Wrath to know what that felt like.

So how can deflation be stopped? Essentially this is the role of central banks through monetary policies. Besides control of the money supply (as detailed in "Easy Money"), the central banks' other tool in controlling inflation is interest rates.

In Canada, the central bank's key mandate is to keep inflation at approximately 2% a year. It knows that some inflation is good — that is why the target is not zero. If the rate rises above 2%, it will react by increasing interest rates because when money is more expensive, people are more careful spending it.

What the central banks don't generally say is that they are worried that the inflation rate will go negative.

The key measure of inflation in Canada is the consumer price index (CPI). Statistics Canada manages it by tracking the cost of more than 600 goods and services annually. Items are adjusted to maintain consistent quantities and qualities so it reflects only price movements.

The CPI all-items index has been in a downward trend over the past few years. For 2011, it was 2.9%; for 2012, it was 1.5%; and for 2013, it was only 0.9%.

This is not deflation; it is disinflation, which is a slowing in the rate of inflation. In a disinflationary period as we are experiencing today, slowing inflation means the central bank is likely to keep rates low since it means rates on consumer loans will also remain low, which stimulates the economy, as people are more likely to borrow and spend when money is cheap.

But we, and many other countries, are on a dangerous path. Deflation, not inflation, is the creature lurking around the corner.