Dubai: With prices of goods and services soaring to unprecedented levels worldwide, central banks are on an aggressive footing to raise interest rates to combat red hot levels of inflation in key economies.
Here’s how it unravels: It all begins with the world’s largest economy US raising interest rates and what immediately follows is the strengthening of the dollar – a currency widely used for international trade.
With the value of the greenback appreciating, countries elsewhere will either raise their interest rates or face a sharp devaluation of their currencies, which further stokes inflation. This is what transpired lately.
Nearly 40 central banks around the world approved increases during September, and the markets have worldwide largely expected all the US central bank’s moves. But now a new worry arises: Deflation.
We expect inflation to fall more rapidly than anticipated, albeit partly because the even-bigger surge in interest rates will send the economy into a mild recession early next year
New worries over ‘deflation’
While inflation is bad for the economy because it raises the cost of living and restricts people from spending; deflation is a converse risk that reflects tumbling demand and is associated with steep world economic downturns. Why is this relevant at a time when economies are trying to tame inflation?
An increasing number of prominent economists worldwide are indicating that the biggest economic risk going forward is deflation, not inflation, as criticism has emerged recently that key central banks worldwide are at risk of pulling the global economy into recession due to their recent aggressive stance.
“We expect inflation to fall more rapidly than anticipated, albeit partly because the even-bigger surge in interest rates will send the economy into a mild recession early next year,” said Paul Ashworth, chief economist at UK-based Capital Economics, with recession seen adding to ‘disinflationary’ pressure.
“We also expect the global economy to be in position to cut interest rates again from late 2023, which should trigger a rebound in economic growth in 2024.”
Disinflation continues until the rate of inflation is zero. After this period, there may be deflation where there is a fall in the general price level.
To put it simply, deflation happens when people don’t want to spend today but want to save for the future. The result of this is a lesser demand for commodities, which leads to a further fall in the price level.
Under disinflation, the economy is generally growing and there is stabilisation in the general price level. The demand for commodities is rising under disinflation. Under deflation, the price can fall at a high rate. Under disinflation, the increase in prices is at a lesser rate. Thus, the rise in prices is gradual.
Top economy US faces risk of deflation
The most recent example of deflation occurred between 2007 and 2008, during the period in US history referred to by economists as the ‘Great Recession’. In the past 60 years, the US has only experienced deflation two times; the Great Recession and in 2015, when inflation barely broke below zero per cent.
Now, the US central bank signaled its concern in May about what it then called the “minor risk” that inflation could turn into a deflationary period of falling prices. In the US, the deflationary drag will slow US economic growth by over 3.4 per cent, as per analysis by US-based economics researcher Brookings.
But that’s not all. People who are pressured by consistently rising prices are already dipping into savings to cover costs with statistics now indicating that the average savings rate is currently just above the lowest level in 14 years recorded recently, which dates to the early days of the financial crisis.
As more money is saved, less money is spent, further decreasing aggregate demand. At this point, people's expectations regarding future inflation are also lowered and they begin to reserve money.
Rising risk of deflation, recession worldwide
With purse strings tightening, the resultant weakening demand for goods and services, and excess or unmet supply of such goods and services, can together squeeze profit margins for an economy’s retailers and force them to offer ample price discounts. This then leads to further price dips.
This is how global recessions and sluggish economic recoveries brings down the rate of inflation. But when inflation is already low, prices can actually begin falling. Falling prices and the expectation of further declines can, in turn, exacerbate the weakness of household or consumer demand.
At a time of recession, people may delay some purchases in hopes of getting better prices. Potential home buyers and business investors are discouraged from borrowing for fear they will have to repay their debts out of earnings and revenues diminished by the decline in prices.
A reduction in interest rates could overcome this barrier to investment. But, since interest rates can’t fall below zero, many of those who worry about deflation fear that the economies will have little power left to support demand and fight deflation if interest rates are already low when deflation begins.
There are many deflationary forces at work in the global economy. These suggest that the current bout of inflation will, ultimately, prove transitory
How bad will the global recession be?
As it stands, the global economy is likely headed for a recession. The question is how much worse it can end up. It’s not a matter of are we going into recession or not, it’s when we’re going to have it and the degree of intensity of the recession, global economists widely reiterate.
“There are many deflationary forces at work in the global economy. These suggest that the current bout of inflation will, ultimately, prove transitory,” noted Azad Zangana, senior European economist, and strategist at British multinational asset management company Schroders.
“Central banks are being forced to normalise interest rates to bring near-term inflation under control, this will have important implications as resultant higher government borrowings will force governments to introduce severe measures as a result. Such measures are deflationary.”
Additionally, the International Monetary Fund (IMF) predicts global growth will slow next year and acknowledged the recession threat in 2023. “The worst is yet to come, and for many 2023 will feel like a recession,” the report said, echoing warnings from the UN, the World Bank, and many global CEOs.
According to these economists, good deflation occurs when the aggregate supply of goods outstrips aggregate demand. This can be result of improved productivity. Bad deflation occurs when aggregate demand falls faster than any growth in aggregate supply.
So, deflation can be worse than inflation if it is brought about through negative factors, such as a lack of demand, and deflation can be better than inflation if it is brought about by positive factors, such as improvements in technology that make the costs of goods and services cheaper.
A little bit of deflation is a product of, and good for, economic growth. But when an economy takes on more debt from developed countries, rapidly falling prices can go together with a financial crisis and recession.
How and when do global recessions come to an end?
Economists have characterised historical episodes in terms of the dates at which economic activity reached a peak before entering a period of decline. The low point on the way down is designated as a ‘trough’, and the episode between the peak and the trough is an ‘economic recession’.
According to the traditional chronology, the recession ends when the economy starts growing again, not when it has grown so much that indicators such as economic growth are back to making new all-time highs. But how can central banks worldwide help tackle recession?
“Central banks can lower short-term interest rates. This can increase consumer confidence and stimulate spending, as the cost of borrowing is lower, meaning the cost of buying items such as cars and homes is also less,” wrote Stephen J. Hall, geo-economics writer at the World Economic Forum.
“Recessions end when growth resumes, no matter how slowly this happens. During the great recession of 2008, for example, governments pumped trillions into the global economy to resuscitate it. Following this unprecedented level of stimulus, markets began to recover.”
How deflation and recession affect you and me
In the short-term, deflation impacts people positively because it increases their purchasing power, allowing them to save more money as their salaries increase relative to their expenses.
Deflation incentivises people to hold onto cash more because they can buy relatively more with their currency in the future than now – this has negative implications that can lead to economic depression worldwide.
So, while higher levels of inflation can be dangerous for an economy as it causes prices of goods to rise too quickly, sometimes more than the salary hikes given to people in line with inflation.
In the same way, deflation can also be bad news for an economy, as people reserve cash instead of spending or investing with the expectation that prices will soon be even lower.
To hedge against deflation, investors can purchase investment-grade bonds, consumer-staple stocks, dividend stocks, and keep their money in cash
How to safeguard your finances from inflation or deflation?
Inflation or deflation are the two major phases of an economy which is caused due to a lot of factors.
According to Brody Dunn, an investment manager at a UAE-based asset advisory firm, here are four general ways which can help you to protect your money whether an economy is in inflation or deflation.
1. Investing in long-term instruments such as debt and equity instruments or in mutual funds.
2. Investing in real estate and safe haven investments like gold
3. Save more and spend wisely
4. Consider buying insurance products which provide financial protection in life and health contingencies
“To hedge against deflation, investors can purchase investment-grade bonds, consumer-staple stocks, dividend stocks, and keep their money in cash. A diversified portfolio can protect against a variety of economic scenarios,” added Dunn.