Deflation: a business perspective

The fear was that historically low levels
of inflation and faltering economic growth could lead to deflation – a
persistent decline in the general level of prices – which in turn could
trigger economic depression, with widespread company and bank failures, a
collapse in world trade, mass unemployment and years of shrinking
economic activity.

While the risk of deflation is now remote
in most countries – given the increasingly unambiguous signs of global
economic recovery – its potential costs are very high and would directly
affect companies. This issues paper was developed to help companies
better understand the phenomenon of deflation, and to give them
practical guidance on possible measures to take if and when the threat
of deflation turns into reality on a future occasion.

It is important not to overestimate the chances of falling into a 1930s-style depression. Short periods of falling prices do not necessarily lead to recession. Changes in relative prices (some rising, some falling) reflect the natural operation of markets. They often result from positive economic developments such as productiv ity improvements and increased competition, allowing more efficient resource allocation. While this can be painful for companies which take out spare capacity, the economy as a whole benefits. Even in Japan, where prices have been falling for a considerable time, the economy has stagnated rather than fallen into a deflationary spiral, though the economy still faces considerable risks as it struggles to purge its huge load of bad debts.

The recent signs of rapid economic growth in the US and recovery in Europe and Japan suggest that the risk of deflation has receded – at least for the time being . But governments and central banks must continue to be alert to the danger over the medium term and retain sufficient policy flexibility to encourage economic recovery, as it is always easier to prevent deflation than to cure it.