For the Wal-Mart shopper, falling prices is a great thing because it means saving money. However, that marketing message only works for Wal-Mart if the shopper actually buys the good.
This dynamic represents the complexity of deflation.
Intuitively, consumers may believe deflation is good because falling prices means saving money. However, it comes with significant behavioural implications which could cause an entire economy to stagnate or even spiral.
It’s why the Federal Reserve has promised to keep monetary policy easy as long as inflation remains below target.
Economist Gary Shilling explains in plain English:
Why does the Fed clearly fear deflation? Steadily declining prices can induce buyers to wait for still-lower prices. So, excess capacity and inventories result and force prices lower. That confirms suspicions and encourages buyers to wait even further. Those deflationary expectations are partly responsible for the slow economic growth in Japan for two decades.
It’s a self-reinforcing cycle, and it’s hard to stop.
Japan is now experimenting with ultra-aggressive monetary and fiscal policy in its effort to stimulate its economy by devaluing its currency and stoking inflation.
In the U.S., inflation continues to be very low, which is why economists like Shilling warn about deflation risks.
For now, it appears that there are more inflationary risks than deflationary risks.
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