INFLATION VERSUS DEFLATION: A DOWNWARD SPIRAL

The PM in his most recent State of the Nation address reiterated that inflation was at an all time low at -1.1% for 2009 when compared to 6.4% in 2008.  Likewise the Statistical Institute of Belize (SIB), upon release of data for third quarter 2009 noted the decline.  There is this perception that negative inflation is a good thing; however it is important to have a clear understanding of the implications of negative inflation and not simply make the assumption that because high inflation is bad then low inflation is good.  In this piece we will review the difference between inflation and deflation and what are some of the effects of a deflationary situation prevailing within the economy.

Inflation is most easily defined as a general rise in price levels, but to be more precise it is a decline in the value of money.  Inflation is measured through the use of price indexes.  In Belize the SIB collects data to determine the Consumer Price Index (CPI).  This is then used to calculate inflation rate.  The CPI is an index that uses a base year and a given basket of goods and services to track price changes over a period of time.  It is compiled and made available for periods ending in February, May, August and November of each year.  So for example the process would identify how much a basket of goods and services would cost in one period compared to another period.  As at August 2009 inflation was -3.6%.  February 2009 was the last period it remained positive at 1.5%.

When inflation is negative or falls below 0% it is then identified as deflation.  Based on the definition of inflation, one can deduce that deflation is a general decrease in price levels; however it is actually an increase in the real value of money.  So one therefore begs the question why would persistent deflation be a bad thing and not one to brag about, that is because deflation has the reverse effect of inflation.  It is first important to understand the types or cause of deflation.  This situation can arise from either an increase in the supply of goods and services or decrease in CPI.  In the case of Belize, it has been a decrease in the CPI since 2009.  Deflation can also occur if there is a build-up of savings alongside a slower rate of growth in money supply coupled with increased demand for money.  This situation is also evident, by reviewing the holdings of savings and term deposits.  In Belize, since September 2009 quasi–money (savings and term deposits) has increased from $1,344M to $1,383M in January 2010; a noted 3% increase.  Deflation may also occur if there is a reduction in economic activity due to reduced demand.  This is quite evident in Belize from the negative growth recorded as at September 2009 at -0.2%.

If deflation is persistent, the value of people’s income will increase as banks stand to benefit at the expense of borrowers and those who were previously willing to save would be more inclined to spend due to the increased purchasing power resulting from declining prices.  The possibility of a liquidity trap becomes apparent, if Central Bank is not able to reduce interest rates so as to provide an incentive for investments to be undertaken.  As in a period of high deflation investments are not seen as profitable.  It would therefore be useful to examine the most recent amendment to the Central Bank Act to determine the effects of those proposed changes.  This examination will be done in a subsequent piece.

In conclusion, this writer makes the point that if Belize were to experience a high level of deflation; unprecedented action would then be required by Central Bank to intervene in the market.  So it is incumbent on government to ensure that this situation does not spiral downwards.

Gwyneth Sydney Nah

Send comments to GwynethNah@gmail.com

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