Deflation
Deflation is a sustained fall in the general level of prices.
Falling prices sound like good news. Sustained across a whole economy, they can be far more dangerous than inflation.
Deflation is a sustained fall in the general level of prices, the mirror image of inflation, so that money gains purchasing power and each unit buys more over time. Though cheaper goods seem welcome, broad and persistent deflation is one of the conditions central banks most fear.
Why falling prices can be dangerous
The danger is that deflation can become self-reinforcing. If people expect prices to keep falling, they delay purchases, waiting for a better deal, which weakens demand, which pushes prices down further. Falling prices also raise the real burden of debt, since loans are repaid in money that is worth more than when borrowed, squeezing borrowers and risking defaults. A downward spiral of weak demand, falling prices, and rising real debt is what makes deflation so corrosive.
The trap for policy
Deflation is also hard to fight, because it can blunt the main tool of monetary policy. Central banks usually stimulate a weak economy by cutting interest rates, but rates cannot fall much below zero, and once there, with prices falling, real interest rates may stay too high to revive demand, a liquidity trap. This is why central banks resort to unconventional measures, such as quantitative easing, when deflation threatens, and why they prefer a small cushion of positive inflation to risking it.
The cautionary case
Japan's experience from the 1990s is the standard warning: a prolonged period of mild deflation and stagnation that proved stubbornly hard to escape despite years of effort, lending its name to fears of a deflationary trap elsewhere. The episode showed how deflation, once entrenched in expectations, can sap an economy's vitality for a generation.
Deflation is a reminder that, in macroeconomics, intuition can mislead: the thing that sounds good for any individual shopper, lower prices, can be poison for an economy as a whole. It is precisely because falling prices can feed on themselves that central banks aim for steady, mild inflation rather than none at all.