Central Banks Fight Against Deflation: Why Deflation Is Not Good

Deflation leads to reduced company earnings, resulting in layoffs and exacerbating unemployment rates. In turn, it would dampen consumer spending and negatively impact the country's economy.

While Indonesians fight against rising inflation, major countries are fighting against the threat of deflation. Jay Pelosky from investment consultancy J2Z Advisory LLC said that fight in 2014 will be against deflation. The phenomenon is especially apparent in the declining trend of CPI in the EU and USA.

Deflation-Inflation Conundrum
The average of USA's yearly CPI was in 3.2% at 2011, lowered to 2.1% in 2012, and most probably will be around one percent in the next announcement at 16 January. Canadian year-on-year inflation report last week (3/1) at 0.9% was also under expectation of 1-3%, and evoked worries of deflation in the area.

Italian CPI last week declined from 0.7% to 0.6%, and Spanish CPI stagnated at 0.3%; made analysts predicted low inflation in the upcoming ECB releases, at around 0.9%. The situation is in contrast with Japan, which had successfully break out of deflation, although they are still struggling to get more inflation.

According to economic theory, deflation, also called as negative inflation, will make companies earning lowers. If companies earn less, then it will make them lay off their workers. Economist Paul Krugman underlined rigidity of wages in these conditions; it is quite impossible to lower salary, except if there are massive unemployment that make people desperate and willing to work on any kind of wages. Therefore, the only solution is lay offs. The 'solution' will result in more unemployment. This, in turn, will lower consumption and give negative influence on national production. In part of common people, low prices on goods and services may be well-received, but basically, deflation is the first sign of slower growth. This is why people are wary of it.

On the opposite end, low inflation is hoped to bring about growth. Companies will work harder because profits increases, employment will expand, household consumption raise as well, and then national production is to go even higher. Although, at large scale, hyperinflation could invite chaos like what happened in Zimbabwe.  

Exporting Deflation
At the end of last month, HSBC said that rather than alleviating deflation tendencies, central banks chose to pour monetary stimulus into the economy, and with it, exporting deflation to other countries. Stimulus programs by BoJ under Abenomics especially devaluate Yen in order to make 'made in Japan' goods and services cheaper for the rest of the world. After Yen loses its safe haven title, the market turns to Dollar. Stronger dollar led to decline in commodity prices, like gold.

So, what will happen in forex market?

Spontaneous reaction from the market on rising inflation usually is gain of one currency against its pair. Rising inflation will open the door for central banks to increase its benchmark interest rate, and the market responds well to such news. If seen that way, then deflation is bad news. However, if we use Japan a year ago as an example, the long-term effect of deflation on exchange rate is in the completely opposite direction. Japan at that time suffers acute deflation, but Yen has the highest exchange rate against any other countries which experienced inflation. It is quite confusing, isn't it? That's why, rather than worrying about how much inflation/deflation and its impact on the pair you trade, it will be far more effective to observe central banks moves.

Regardless of economic improvement in the US and Europe, World's central banks always think of ways to counter deflation. With one and other, they have been and will continue to seek ways to prevent slowing economic growth. One recent popular move is monetary stimulus in the shape of Quantitative Easing (QE). QE is hoped to push banks to lend money and intensify activities in the real economy.

The problem is, QE is as ineffective as Funding for Lending scheme (FLS) from Bank of England. Such schemes successfully export deflation, but unable to entice banks to channel cash to households and small and medium enterprises (SMEs). They keep blowing bubbles in financial and property sector. A comprehensive overhaul as Japan do with Abenomics may be more successful, but it is too risky. This is why, the appropriate policy in addressing deflation is still a mystery.

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