What is deflation?

The risk of deflation in China is growing, data suggested on Wednesday, as policymakers tried to reassure markets that the economy can stay on track and state banks were suspected of intervening in offshore markets to bolster the yuan. Some foreign central banks are increasingly worried about the impact falling Chinese prices and a weaker yuan could have on their economies, following a surprise devaluation in the currency last month.

Following the release of April-June gross domestic product (GDP) numbers last week, chief economic adviser Arvind Subramanian reportedly said: “The one real challenge that looms ahead for India’s economy appears not to be price inflation but possibly price deflation.” He has also been quoted as saying: “India is in or close to deflation territory.”

Subramanian’s assessment follows RBI governor Raghuram Rajan’s concern in a speech in late August that “… while CPI inflation has moderated, inflation expectations amongst the public are still high, creating a gap between the real rates that savers expect and the rates corporations think they pay”. Perhaps this is a way of putting pressure on the RBI to announce rate cuts.

In general, deflation is when the average price of goods falls. When the inflation rate falls below zero, indicating negative inflation, we know that there has been deflation. Deflation is caused by a decrease in the supply of money or increase in the supply of goods. It also happens where there is a decrease in the demand for goods or increase in the demand for money. Although deflation is generally considered a negative thing, it is not always bad.

Wells Capital Management chief investment officer, James Paulsen once wrote that good inflation happens when businesses can produce goods at lower costs without losing profits or raising unemployment, says themoneyalert.com. When prices go down, consumers delay purchases thinking that prices will continue to fall. As a result, companies make less money, leading them to layoff employees.

When unemployment increases, there is lower demand for products because unemployed consumers can’t afford more purchases. It can become a vicious cycle. Until the government can find a way to increase consumer and business spending - usually by lowering interest rates to stimulate the economy - equity prices will take a severe beating.

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