Will prices fall again soon? Deflation is the real danger

Are prices falling again soon?
Deflation is the real danger

From Max Borowski

Are we threatened by persistent high inflation after the Corona crisis or are rising prices just a temporary phenomenon? Some experts even predict an impending deflation – with dangerous consequences for the economy.

Inflation is back – and it scares many. In Germany, consumer prices rose year-on-year in May at the rate they have not for more than ten years, and not much less in June. The Bundesbank expects an inflation rate of possibly more than four percent by the end of this year. In the USA, the rise in consumer prices has already clearly exceeded the threshold of more than five percent.

Prices stagnated for years and at times even fell at the beginning of the 2020 pandemic. In a very short time this situation has completely changed. After the crisis, the demand for many products, raw materials and energy sources picks up, meanwhile the supply is in some cases severely restricted due to interrupted supply chains. As a result, prices skyrocket. In Germany, the new CO2 tax and the VAT, which has been payable in full since the beginning of the year, are also adding special effects.

This sudden spike is causing concern. Savers and investors fear that their assets will lose value massively if the inflation rate remains high in the medium term. At the same time, the central banks might have to tighten their ultra-loose monetary policy and withdraw liquidity from the economy and the financial market. Not only would that be bad for the stock market, it would make it more difficult for all companies to raise capital.

But while some experts, such as the former chief economist of the International Monetary Fund, urgently warn against waking the “monster” inflation, others assume that the causes of the current price increases are special effects with a short lifespan. For example, the Bundesbank predicts a further rise in inflation this year, but it will then fall back to below two percent. Still other experts point out that the real threat to the economy is not inflation, which has recently been discussed so much, but – on the contrary – dangerous deflation. Some of their arguments in a nutshell:

  • Some of the particularly sharp increases in prices for manufacturers and raw materials, which recently fueled inflation expectations, are already falling again. This can be seen particularly clearly with Lumber in the USA. This could lead to the hamster effect also diminishing due to panicked purchases by users of such raw materials. The prices for some goods could even temporarily fall back below the starting level before the pandemic. In the case of consumer goods, the massively disrupted sea trade routes are currently reducing the supply, increasing prices, and in some cases ensuring that producers in low-wage Asian countries have lost market shares to competitors in high-priced locations such as Europe and the USA. But the Asian manufacturers will do everything possible to regain this market share, says economist Lacy Hunt. For the USA, he predicts a price war between American and Asian companies.
  • Even if consumer prices should stabilize slightly above this level, the base effect could lead to inflation rates that are at times well below zero. Economists call the base effect the phenomenon that statistics such as consumer prices reflect not only the current changes, but – in a year-on-year comparison – those of a year ago. The energy prices, which fell sharply last year and have since recovered, are currently causing high annual inflation rates. This effect could also be reversed. According to the economist and financial analyst Bilal, if the general consumer price trend in the US should return to its long-term trend after the current surge to more than five percent, the inflation rate would fall to -1.4 percent in the coming year due to the base effect in the statistics Hafeez calculates.
  • Some economists argue that debt has a deflationary effect in the long run. Many fear that the current record borrowing by both public and private companies and households, supported by the “money printing” central banks, will fuel inflation. That has not been the case since the beginning of the ultra-loose monetary policy. On the contrary, says Hunt, the high debt levels even have a deflationary effect in the long term. At the latest when the reduction in debt levels, which German politicians in particular are striving for, reduces the supply of money in the financial system.
  • Society will continue to age. This goes hand in hand with lower consumer spending and higher savings rates – interest and price dampening effects.
  • Technological development, a factor that has been dampening price developments for decades, continues. In many areas, companies increased their efficiency during the pandemic, for example by pushing ahead with digitization.

The fear of inflation, coupled with spectacular images of people pushing wheelbarrows full of worthless money, is firmly entrenched in people’s minds. Except for the extreme case of such hyperinflation, even a small amount of deflation is seen as more damaging to the economy. The expectation of falling prices not only inhibits consumption, but also investment and the willingness to increase wages, for example. The entire economic cycle threatens to stall. At the same time, as income falls, the value of debt increases. The burden on private and public debtors continues to increase.