The recent CPI figures published by the Dept of Statistics in Wellington show that there was a 1% in the CPI from the June 2011 quarter to the June 2012 – the lowest annual rise since 1999. This is at the bottom of the Policy Target Agreement which stipulates that the CPI should be kept between 1-3%. The question now is whether annual headline CPI inflation can avoid dipping below the bottom of the 1.0% and whether the threat of deflation is a serious concern?
Deflation – why is it a concern?
In the short-term a period of deflation can help the economy. Falling prices mean that consumers can buy more with their income and rising purchasing power would provide a boost to confidence and could assist the economy by increased growth.
However a longer period of deflation can be very damaging to an economy for two reasons:
1. Expecting prices to be lower in the future consumers put off purchasing goods and services in the expectation that they will get lower. This leads to a contraction of demand and ultimately lower growth. Japan in the 1990’s is a good example of this – see graph below.
2. A more dangerous scenario is debt deflation. As prices fall the real value (nominal – CPI) of debt increases – just as it decreases if prices are rising.
The increase in debt that people have taken on over the last 5 years makes this latter point very worrying. However, commentators have suggested that deflation shouldn’t become a problem in NZ.
ECONFIX 