Why is deflation dangerous?? Mario Draghi takes rapid turns !

European Central Bank President Mario Draghi said he can’t exclude the risk of deflation in the euro area, hinting that the likelihood of large-scale quantitative easing is increasing.

European Central Bank President Mario Draghi’s Feb. 6 comments playing down the risk of deflation. 
Read here: http://www.ecb.europa.eu/press/pressconf/2014/html/is140206.en.html

But What is Deflation and Why is it dangerous?

The ogre stalking Europe’s weak economies isn’t the one people have learned to fear. The monster isn’t inflation but its opposite: falling prices. Its name is deflation and it appears friendly. Why be afraid when the cash in people’s wallets buys more fuel and televisions, not less? Because when deflation grabs hold, companies and consumers stop spending. It strangles borrowers because their debts get harder to repay — a menace for countries struggling to exit the worst recession in a generation. In this fairy tale, inflation comes dressed in shining armor as policy makers debate how to create just enough of it to keep deflation at bay.

• The Situation

Six years since the 2008 financial crisis turned the global economy upside down, deflation threatens to drag out the turmoil in Europe. The continent’s economies have failed to recover the momentum needed to stimulate slow-but-steady price increases, which most central bankers consider desirable. In the euro zone, inflation slid to its weakest in five years in 2014, with drops in Greece and Spain.  The slide in oil is adding to the deflationary pull and prices are expected to fall going into 2015. About a third of the goods that Europeans commonly buy are declining in price, including clothes and carpets, according to Jefferies International. In Japan, inflation only began showing signs of life in 2013 as the central bank targeted a 2 percent price gain in an all-out bet to shake off more than a decade of deflation and stagnation. Japan fell back into recession in 2014 and inflation risks slipping anew after an increase in the consumption tax.

SOURCE: EUROSTAT

The Background

When prices rise at a slower pace it can help consumers boost their purchasing power. But when they actually drop, economic activity can screech to a halt. Households hold off making purchases as they anticipate further price declines; companies postpone investment and hiring as they are forced to cut prices. Sliding prices eat into sales and tax receipts, limiting pay raises and profit margins. They add to the debt burdens of companies and governments that would otherwise be eroded by inflation. Deflation fueled two of the worst economic disasters in modern times — the Great Depression of the 1930s, and the less catastrophic but more recent experience of Japan’s lost decades with almost no economic growth.  Deflation took hold in Japan in the 1990s when banks, wounded by a burst real estate bubble, stopped lending. Wages stagnated and consumers reined in spending.  The International Monetary Fund has studied which economies are vulnerable to deflation, and has raised concern that even a period of ultra-low inflation could do damage. “If inflation is the genie,” IMF Managing Director Christine Lagarde warned in January 2014, “then deflation is the ogre that must be fought decisively.”

SOURCE: JAPAN MINISTRY OF INTERNAL AFFAIRS AND COMMUNICATIONS

The Argument

Central bankers find it easier to beat inflation than deflation. When prices rise too fast, policy makers raise interest rates, then pull back when the economy slows. It’s harder to calibrate the right dose of medicine to ward off deflation. Interest rates in most large countries are still near zero, and the European Central Bank even cut a key rate intonegative territory in June 2014. In Greece, deflation may be a price worth paying to make the country competitive again after years of living beyond its means. Bond-buying programs like those that helped revive the U.S. and Japan have also had dangerous side effects. They’ve sent money flowing into stocks and property, boosting the prices of assets rather than products, raising concern that too much easing was creating bubbles. Even so, the ECB has started buying private-sector assets to boost prices, and is considering further steps to ensure that it keeps deflation at bay. Even when the threat of deflation seems small, history tells us that it’s a huge risk.

THE REFERENCE SHELF

• Former U.S. Federal Reserve Chairman Ben S. Bernanke’s 2002 speech on deflation and his 1991 research paper on the Great Depression.
• Studies from a 2003 symposium on deflation hosted by the Federal Reserve Bank of Minneapolis.
• IMF research on the risk of deflation in the euro area and IMF Managing Director Christine Lagarde’s speech calling deflation an “ogre.”
• FIRST PUBLISHED MARCH 19, 2014

Ref:

www.bloombergview.com/quicktake/deflation

http://www.bloomberg.com/news/2015-01-02/draghi-says-ecb-prepares-action-as-deflation-risk-non-negligible.html