The graph above is of the seasonally adjusted month on month change in the U.S. Consumer Price Index. The 1.7% plunge in November 2008 has raised some red flags.
In our most recent newsletter entitled "The Great Deflation", we discussed the dire economic consequences of a deflationary spiral. Today the world faces a real risk of entering a deflationary spiral with grave repercussions as it has the potential of turning what is at the moment a benign recession into a full fledged economic depression. It is therefore not surprising that in light of this threat, nervous policymakers have been very active in trying to reinvigorate the economy. This is especially noticeable in the U.S. where the target interest rates has been brought down to zero and where billions (with a promise of more to come) are being spent on bailing out a growing number of institutions.
As consumers, we may perceive deflation, which is a general and sustained drop in the price of goods and services, as something that is desirable considering that it tends to improve our purchasing power. The problem, however, is when deflation continues over a sufficiently long period of time that it starts influencing expectations of future prices. If households believe that the drop in prices are likely to continue into the future, they will postpone purchases until a later date. Producers will also adapt to these changes by cutting back on capital expenditure as they see their return on investment drop.
With these developments the consumer may well end up worse off because although deflation will improve their purchasing power, they may end up being worse off as their standard of living could suffer if firms lay off more workers to counter the drop in sales.
