What Is Deflation?

Over the last few years, all we’ve heard across the world is the word inflation, its impact on our finances and the effects it can have on the economy, but what is deflation? As you may have already guessed, deflation is the opposite of inflation, but just because it seems that inflation is all bad it doesn’t mean deflation is all positive. Deflation can have some serious effects on the economy and your day-to-day life. In this piece, we will explain what deflation is, its positives and its negatives.

What is Deflation?

Deflation is when the overall prices of goods and services fall over time. Think of it like this: if the cost of things like groceries, petrol, or housing goes down instead of up, that’s deflation in action.

However, deflation isn’t just about lower prices. It often signals that there’s less demand for goods and services. When demand drops, businesses cut prices to attract customers. But this can lead to a cycle: businesses lower prices, consumers hold off on buying, and businesses lower prices even more. It sounds great initially but in the long term this cycle isn’t sustainable.

Deflation vs Inflation: What's the Difference?

Inflation is when prices go up over time (think rising cost of living, from rent to petrol). Deflation is when prices go down over time, which usually means the economy is shrinking or there’s weak demand.

While both inflation and deflation impact the economy, deflation is generally seen as more dangerous because it can spiral into economic decline.

What Causes Deflation?

Deflation doesn’t happen overnight. It’s usually a result of a few things happening at once. Here are a few reasons that might cause it:

Decreased Consumer Spending 

If people stop spending, businesses can’t sell enough goods, so they lower prices. But if consumers expect prices to keep dropping, they might hold off on purchases altogether, leading to even weaker demand.

Too Much Supply

If there’s more of something than people actually want or need (like if there’s too much housing or too many cars), businesses may cut prices to sell off their stock.

Improved Productivity 

Sometimes, companies find ways to make things cheaper, like with new technology. While that sounds good, it can lead to deflation if they pass on the savings to consumers without boosting wages or demand.

Less Money in the Economy 

If the Reserve Bank of Australia (RBA) pulls back on money supply or raises interest rates, it can lead to less spending, dropping demand and prices.

How Does Deflation Affect the Economy?

Lower prices might sound like a good thing, but deflation can be a real problem. Here’s how it can hurt the economy:

Lower Consumer Spending 

If people expect prices to fall, they may delay buying things, reducing demand. Businesses might cut back on production or even lay off workers.

Bigger Debt Burden 

As prices drop, the real value of debt goes up. So, if you owe money (say on a mortgage or personal loan), paying it back becomes harder in real terms, which can lead to more defaults.

Rising Unemployment 

As businesses struggle with lower sales, they may lay off workers. This, in turn, leads to even less spending, making things worse.

Lower Wages 

In a deflationary environment, businesses might also cut wages to save money, which reduces consumers' ability to spend, furthering the cycle.

Economic Recession 

If deflation goes on long enough, it can lead to a broader economic downturn. A "liquidity trap" can set in, where traditional tools like cutting interest rates no longer work to stimulate the economy.

What Could Deflation Mean for Australians?

Although we haven’t seen much deflation in Australia recently, it’s still something to be aware of, especially with global uncertainties and local challenges. Here’s how deflation might affect you personally:

Falling House Prices 

Deflation could lead to lower property prices. While that might sound good for first-time homebuyers, it could also mean people end up with mortgages higher than their home’s value, causing financial stress.

Job Losses 

If businesses can’t sell enough goods, they might lay off staff. Industries like retail, manufacturing, or construction could be hit hard by deflation, leading to job insecurity.

Lower Interest Rates 

To fight deflation, the RBA would likely lower interest rates. While this could make loans cheaper, it may not boost spending if consumers are too hesitant to open their wallets.

Lower Wages 

As businesses struggle to survive, they may offer lower wages or freeze hiring. This could lead to reduced disposable income for many people.

Can Deflation Be Prevented?

Governments and central banks are constantly watching inflation and deflation, since both can have serious effects on the economy. If deflation becomes a risk, the Reserve Bank of Australia can step in by cutting interest rates, injecting money into the economy, or using fiscal policy to encourage spending. In extreme cases, they may even use a strategy called “quantitative easing,” where they create new money to boost the economy.

But managing deflation isn’t always easy. It often requires a mix of policies to restore confidence and get people spending again.

Summary

On face value, deflation sounds appealing with lower prices, but it can lead to serious long-term problems like job losses, higher debt burdens, and a sluggish economy. Even though Australia doesn’t face deflation often, understanding what it is and how it could affect you is important for making smart financial decisions. Keep an eye on things like inflation rates, interest rates, and consumer spending to get a sense of where the economy is headed and how it might impact your wallet.

Here at the GLOSS Vault, we have made it our mission to help as many people like you across Australia and New Zealand feel in control of your money and ensure you’re getting the most out of it. To find out more about us and what we do click here. If you’d like to see our app in action for yourself head here!