The Wall Street Journal reported that consumer prices fell .5 percent across the European Union in January, making it the most rapid drop since 1997. The fall in consumer prices has led to an increase in consumer spending, but some fear that if the falls in consumer prices continue then the EU may be facing a deflationary spiral.
Deflation, or negative inflation, is a fall in the price level of goods and services which increases the real value of money over time by allowing one to buy more goods and services with the same amount of money. While this may sound like a good thing – one euro could buy more goods in January than it could in December – central bankers and economists are often very wary of deflation. Generally a low and steady rate of inflation, or an increase in the level of prices for goods and services, of two to three percent is recommended by central bankers and economists alike.
Deflation is considered dangerous to the economy for a few reasons. One major reason is that people may become accustomed to falling prices and choose to hold onto their money in anticipation of a further price drop as opposed to spending their money. This is because contrary to normal economic conditions, holding onto money has become an investment – if one has 100 euros and deflation is three percent, then one year from today the same 100 euros can be used to buy three percent more goods and services than before. In theory, people would be able to buy 103 euros’ worth of goods and services instead of 100.
Similarly, as people are less willing to spend they are also less inclined to borrow. People anticipate that the money they have to pay back in the future, in the form of interest payments and the principal payment, will be more valuable than the money they are borrowing now.
A final reason that economists fear deflation is that wages often have to fall with prices, which can lead to a rise in unemployment if workers are unwilling to accept lower wages.
Much of the decrease in consumer prices can be attributed to the plummeting energy prices, and a return to historical prices may alleviate the threat of deflation; however, the European Central Bank is not taking any chances. According to the Wall Street Journal, “The ECB announced on Jan. 22 that it will … embark on a program known as quantitative easing under which it will buy more than one trillion euros of mostly government bonds by September 2016.” This program could help lift inflation closer to the EU’s two percent target.
Feb. 27, 2015