What is deflation?

Deflation is a sustained, broad-based fall in the general level of prices across an economy. It is the opposite of inflation. Where inflation means prices are rising over time, deflation means they are falling. A single price dropping, or prices falling temporarily, does not constitute deflation. The term applies when prices across the economy are falling consistently and the trend is expected to continue.

Why deflation is more feared than inflation

Central banks, including the Bank of England, target a positive inflation rate of 2 percent rather than zero or below, deliberately. The reason is that deflation, once entrenched, is exceptionally difficult to escape and causes damage to an economy that is qualitatively different from the damage caused by moderate inflation.

The core problem is the deflationary spiral. If prices are falling, consumers have an incentive to delay purchases: why buy today if the same item will be cheaper next month? Deferred spending means lower revenues for businesses, which leads to cost cuts, which means lower wages and higher unemployment, which means less consumer spending, which drives prices down further. The spiral reinforces itself. Japan spent most of the 1990s and 2000s trapped in mild deflation and sluggish growth, a period economists refer to as the Lost Decade, and never fully escaped the dynamic until aggressive monetary policy in the 2010s.

Deflation is also particularly damaging for debtors. If prices and wages fall but the nominal value of debt does not, the real burden of repayment increases. Households and businesses carrying debt find it harder to service as their nominal income falls. This is what happened during the Great Depression of the 1930s, when falling prices caused mass debt defaults and banking collapses.

What causes deflation

Deflation typically has one of three causes, or a combination of them. The first is a collapse in demand: when spending falls sharply, businesses cut prices to shift inventory, and if the demand collapse is severe enough and sustained, prices fall across the board. The second is a positive supply shock: a sudden, large increase in productive capacity (for instance, a major technological improvement reducing production costs) can push prices down. This form of deflation is less harmful because it reflects real economic improvement. The third is debt deflation: when credit contracts sharply, the money supply shrinks and prices fall as a consequence.

Is the UK at risk of deflation?

The UK is not currently in deflation. CPI inflation has fallen from its 2022 peak but remains positive, settling towards the Bank of England's 2 percent target. The more immediate concern in the UK is that inflation stays above target for longer than expected rather than falling into deflation.

The deflationary risk scenario for the UK would involve a sharper-than-expected economic slowdown, a significant contraction in consumer credit, and a collapse in business investment coinciding. That is not the base case. It is a tail risk worth understanding, particularly given the level of household debt and the sensitivity of consumer spending to credit conditions, both of which are tracked by the CPIx. The Briefed daily briefing covers the inflation data that defines where the UK sits on the inflation-deflation spectrum, weekdays at 6:45am. Free to read.