Tuesday, July 1, 2008

Rising Inflation May Lead To Deflation

Rising hot air balloon signifying inflationInflation is certainly on the minds of the masses today as it appears each new day brings with it a new record price for oil and food, among other things. Inflation is especially bad right now because wages aren’t keeping up with it and thus our buying power is being reduced with each passing minute. But while Inflation is certainly a bad thing, deflation may be even worse, and according to a report issued by the Bank of International Settlements (BIS), which acts as the bank for central banks, we may be heading for just that.

Deflation occurs when prices fall. That may seem like a great thing, but deflation is typically anything but great. The greatest depressions are accompanied not by inflation, but by deflation. Our economies today are driven by spending, and inflation spurs spending. If you know that something is going to be more expensive next month, or next year, you are probably going to buy it now, if possible. In fact, you may even borrow money to buy that good or service now. Not only do you benefit by acquiring the product at a lower price now, but assuming your loan is fixed, you win that way, too. Taking money now and paying it back with inflated dollars sounds like a pretty good plan, right? In an inflationary environment there is little incentive to save because money saved simply loses value.

On the other hand, in a deflationary environment, people are encouraged to save. They know that every day they hold out to buy something, the cheaper it is going to be. In addition, they most certainly do not want to take out a loan, because they would have to pay it back in appreciating dollars. They would be much better off to simply save their money and wait until they have enough to buy something outright. Naturally, this type of scenario doesn’t bode well for an economy that is built on spending. When people stop spending, a funny thing happens: businesses struggle and eventually close. That, of course, leads to people getting laid off, which leads to even less spending, and it becomes a vicious cycle. This is how depressions start--and become really bad really fast.

In its annual report, BIS said that the impact of rising food and energy prices on consumers' incomes, combined with heavy household debts and a pullback in bank lending, may lead to a slowdown in global growth that "could prove to be much greater and longer-lasting than would be required to keep inflation under control…Over time, this could potentially even lead to deflation," according to the Wall Street Journal. The BIS went on to essentially blame the central banks for the current financial problems, claiming that they kept interest rates too low for too long.

In a bit of good news though, the BIS said they see the chances of deflation as fairly low, and consider inflation to be a much greater threat at this time. The BIS is urging most central banks to consider raising their interest rates to combat this danger.

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