Dan is a veteran writer and editor specializing in financial news, market education, and public relations. Earlier in his career, he spent nearly a decade covering corporate news and markets for Dow Jones Newswires, with his articles frequently appearing in The Wall Street Journal and Barronâs.
Doug is a Chartered Alternative Investment Analyst who spent more than 20 years as a derivatives market maker and asset manager before “reincarnating” as a financial media professional a decade ago.
Before joining Britannica, Doug spent nearly six years managing content marketing projects for a dozen clients, including The Ticker Tape, TD Ameritrade’s market news and financial education site for retail investors. He has been a CAIA charter holder since 2006, and also held a Series 3 license during his years as a derivatives specialist.
Doug previously served as Regional Director for the Chicago region of PRMIA, the Professional Risk Managers’ International Association, and he also served as editor of Intelligent Risk, PRMIA’s quarterly member newsletter. He holds a BS from the University of Illinois at Urbana-Champaign and an MBA from Illinois Institute of Technology, Stuart School of Business.
What is the Goldilocks scenario in terms of inflation?
The Goldilocks scenario refers to a situation where inflation is stable and predictable, not too high or too low, allowing consumers, companies, and governments to make long-term spending and investment decisions with less uncertainty. Although economists donât agree on what constitutes that âjust rightâ level, the Fed targets a 2% inflation rate.
Why is deflation considered harmful to the economy?
Deflation is harmful because it leads to decreased spending, rising inventories, job losses, and a decrease in GDP as companies canât sell products at a profit, causing a deflationary spiral. As prices fall, companies struggle to sell goods at a profit, which can trigger a deflationary spiral. The Great Depression is the most well-known example, when sustained deflation deepened the economic collapse and prolonged recovery.
How did the COVID-19 pandemic contribute to inflation in the early 2020s?
The pandemic caused widespread shutdowns of factories, ports, and transportation networks, disrupting global supply chains and creating shortages of goods and materials. At the same time, governments responded with large-scale stimulus programs and kept interest rates low, which boosted consumer demand. With too much money chasing too few goods, prices began to rise. Labor shortages, shipping delays, and a surge in energy costs added to the pressure, contributing to the sharpest inflation spike in decades.
No one likes paying more for something than they did last month or last year. Still, a little inflation is arguably essential for a healthy economy. The time to worry is when inflation goes âhyperââor when it reverses and prices fall.
When inflation is relatively stable over long periods, you donât need to fret much about how rising or falling prices might affect your plans to make a large purchase or borrow money. You can also hold onto money for years without inflation eroding most of its value. This is sometimes called a âGoldilocksâ scenario, where inflation isnât too hot or too cold. Although economists donât agree on what constitutes not-too-hot/not-too-cold inflation, the U.S. Federal Reserve (Fed) targets a 2% inflation rate that may represent a âjust rightâ level.
Ideally, economic inflation shouldnât be too hot or too cold.
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Key Points
Inflation is a natural and healthy phenomenon until it gets out of control and hurts the economy.
Deflation is marked by falling prices, often the hallmark of severe recessions and even the Great Depression.
Consumer expectations can drive behavior such that inflation and deflation spiral out of control.
When inflation sizzles, the value of savings erodes, borrowing costs tend to rise, and many people canât afford essential items. Gross domestic product (GDP) often begins to weaken.
When prices deflate, people hold onto their money as they wait for prices to fall even more. Inventories build, wages deflate, people lose their jobs, and, once again, GDP sags. One key task of the Fed is maintaining price stability in order to keep Goldilocks inflation in place. But no economy is immune from outbreaks of high and low inflation that can upend growth and jump-start the misery meter.
Why does inflation occur?
Prices tend to rise when:
Populations grow.
Economies get richer.
Demand increases.
Commodities become scarcer and more expensive.
Companies hike prices to meet rising demand, or to pay higher wages and buy more expensive raw materials.
Inflation can also occur when governments inject money into the economy. This can reduce the value of the currency relative to the things it will buy, causing producers to demand more cash for the things they make and sell.
See how pricesâand your purchasing powerâhave changed over time.
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Falling prices? Ouch
Deflation, the opposite of inflation, is typically a drag on an economy. A deflationary spiral is when:
People expect prices to fall, so they wait to spend.
Low spending forces companies to reduce prices further to try to attract customers.
Companies canât invest in new products or plants with less money coming in, so they stagnate or go out of business.
People lose their jobs as companies close or downsize.
The unemployed are less likely to spend, so demand and prices fall even more.
To better understand inflation versus deflation and their effect on the economy, it helps to study how economies have reacted in both cases. Itâs not pretty.
Deflationâs impact
It may sound counterintuitive, but falling prices can actually be associated with more misery than rising ones. The worst economic crisis in U.S. history, the Great Depression, was characterized by deflation. More recently, the COVID-19 pandemic shut down the global economy in 2020 and triggered a deep (but ultimately short) global recession. What memory surfaces (besides being cooped up playing board games with your family)?
Maybe itâs the rock-bottom price of gasoline. At one point in 2020, oilâs value actually fell below zero as producers became willing to pay to have the stuff taken away. Almost no one was traveling, and all that crude oil suddenly had no present-day value. Prices at gas stations across the country fell below $2 a gallon. But that didnât benefit many people, because most werenât going anywhere, particularly during the pandemic-related shutdowns.
Deflation was also widespread during the Great Depression. This severe downturn had many possible causes, but one stands out in terms of deflation: Consumers lost their desire to spend. This began a deflationary spiral where companies saw inventories rise and had to lay off workers, fueling more economic weakness that reduced spending even more. Anyone wanting to sell something had no choice but to lower prices.
As prices fell, economic growth slowed further, in part because companies lost their incentive to make products they knew couldnât be sold at a profit. That forced more layoffs, raising unemployment and pressing GDP further into the red.
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Expansion, peak, contraction, recovery. Repeat.
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Between the peak and the trough of the downturn from late 1929 to early 1933, industrial production in the U.S. declined 47% and real GDP fell 30%. The U.S. Consumer Price Index (CPI), which measures price growth, fell 33% during that period. And unemployment? Around 25%. One in four workers couldnât find a job. Thatâs the true and sad impact of deflation.
Hyperinflation and the economy
The opposite of deflation is hyperinflation. One of the best-known examples of hyperinflation happened in Germany after World War I. The government printed so much money trying to pay off war-related debt that the value of its currency collapsed. By November 1923, one U.S. dollar was equivalent to 1,000,0000,000,000 (one trillion) marks, compared with four marks before the war. A wheelbarrow full of money couldnât buy a newspaper. Many people burned money in their fireplaces to keep warm.
That kind of hyperinflation didnât just mean paying a fortune for bread. It destroyed peopleâs savings. Imagine a German worker whoâd spent their entire life saving a million marks ($250,000 in prewar value). Suddenly, that entire million couldnât even buy a newspaper.
Although that extent of hyperinflation is rare, even a bit of high inflationâlike what the U.S. and many other countries experienced in the early 2020sâcan erode savings and hurt quality of life.
Wage and price spirals
After the COVID-19 pandemic, inflation screamed to 40-year highs. Consider some reasons:
The entire global economy had been shut down for roughly a year by the spring of 2021.
Many companies didnât have enough employees (due to COVID-19 shutdowns and resignations) to make as many productsâthings like automobiles and computer chips.
When governments sent consumers money and lowered interest rates to encourage spending and investment, it unleashed a wave of demand as economies reopened.
Companies werenât able to ramp up production quickly enough to meet the new demand, and prices began rising quickly amid product scarcity.
Making matters worse, crude oil spiked in 2022 after Russia invaded Ukraine and Western governments limited Russian energy imports. This gave companies the unappetizing choice of swallowing higher raw materials costs (hurting their operating margins and thus profits) or passing along their heftier costs to consumers. The first option hurts investors, the second hurts consumers. Both hurt the economy.
Prices for gasoline, cars, and groceries rose more quickly than in 40 years, and people demanded higher wages to pay for the increased cost of goods. Companies did their best, but many werenât able to give raises that kept up with inflation. A 5% raise may sound great, but not if prices recently skyrocketed 9%. When prices rise faster than wages, consumers lose. They might spend less, slowing economic growth. Indeed, U.S. GDP growth fell in the first half of 2022 after rising dramatically in 2021.
Some economists began to fear a âwage-price spiral,â like the one in 1979â81. Back then, people got used to double-digit price gains, ramped up their inflationary expectations for the future, and demanded double-digit wage hikes to keep up with this perceived future inflation. Companies tried to accommodate them, but jacked up prices to afford paying the higher salaries. And so on and so onâa cycle that helped fuel the stagflation of the late 1970s and early 1980s.
The cycle only stopped when the Fed stepped in and increased borrowing costs to record highs. This cooled inflation, but subjected the economy to two deep recessions in the early â80s that fueled double-digit unemployment.
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INFLATION, RECESSION, AND INTEREST RATE POLICY. When inflation (blue line) rises, the Federal Reserve pushes interest rates (red line) higher to cool things down, often resulting in a recession (shaded areas). When inflation gets too low, the Fed lowers rates to stoke the economic embers.
Federal Reserve Bank of Dallas, Trimmed Mean PCE Inflation Rate [PCETRIM12M159SFRBDAL]; Board of Governors of the Federal Reserve System (US), Federal Funds Effective Rate [FEDFUNDS]; retrieved from Federal Reserve Bank of St. Louis, https://fred.stlouis.org, October 17, 2022
The bottom line
If one thing stands out about both inflation and deflation, itâs lack of stability. People donât know how much things will cost in the future, but base their spending decisions on expectations of what goods might cost. Companies also donât know what to expect, and central banks have to react quickly by raising or lowering borrowing costs. Sometimes central banks resort to âquantitative easing,â in which they buy bonds or other assets to stimulate growth (and fend off possible deflation).
In a Goldilocks economy where inflation is relatively stable and predictable year after year, consumers, companies, and the government can make long-term spending and investment decisions with less uncertainty. In general, markets donât like uncertainty, so stocks and the overall economy tend to do better when Goldilocks finds the inflation rate thatâs âjust right.âHyperinflation in the Weimar Republic | britannica.com
