Back in January, I wrote about how some economists were arguing that a little deflation might not be such a bad thing (you can refresh your memory here).
Deflation, or falling prices (negative inflation), is widely feared by economists because falling prices lead to lower consumer spending, which is a major component of economic growth. Producers respond by slowing down their factories, which leads to layoffs and wage reductions that in turn leads to falling demand and lower prices.
It’s a vicious circle that economists aren’t sure how to break, as we can see from the Japanese experience of the last 20 years. The point of the article back in January was that as long as there wasn’t too much deflation, consumers and producers could still find a reasonable equilibrium, just as we do with a little bit of inflation.
Over the weekend, the Wall Street Journal ran an article (found here, though a subscription may be required) pointing out that Switzerland has been experiencing deflation for the past five years and they’re doing just fine with some economic growth (around 1.25 percent) and low unemployment (around 3.4 percent).
The article quotes a report by the Bank for International Settlements (the central banker’s central bank), who said that ‘lower prices increases real income and wealth,’ which is true: if your salary stays the same or increases while overall prices fall, you can buy more goods and services or save some money.
While it’s interesting to see a developed economy do reasonably well with deflation, I’m not sure if the story would translate well to other places – especially the rest of Europe where growth is weaker and unemployment still unbearably high.
The rest of Europe continues to face deflation as it has for the past several years and this week, markets expect that the European Central Bank (ECB) will add to their already enormous quantitative easing program in an effort to combat deflation.
Deflation is still somewhat of a threat in the US, although probably less so than across the Atlantic. And although it’s still unlikely, you can think of your bond portfolio as a deflation hedge because the coupon payments will stay the same while prices fall.
The Fed would also want to lower interest rates or go back to buying bonds on the open market, which would help bond prices.
For now though, we’ll just have to wait and see what happens, but it is a bit of a relief to see that Switzerland has been coping with deflation reasonably well over the past few years.