Why Can't We Do Wthout Inflation?

Inflation is always associated with something unfavourable for consumers as well as for businesses. The textbook rule is that 2% inflation is healthy for the economy.

Therefore, over recent years—especially during periods of peak inflation when rates approached or exceeded 10%—central bank governors have stated that their target is the coveted 2%.

The reasons:

1. In periods when people expect prices to rise, they generally assume this will continue for some time. This sets in motion a cycle that motivates them to spend more—and to spend now.

2. This applies to purchases such as cars, household appliances, and other durable goods that are used over an extended period, even if they require a larger outlay. Why is this? Because of the expectation that these items will become more expensive in the future. Essential goods, like food, which cannot be stored long-term, also increase in price, causing us to pay even more.

3. In all cases, however, companies generate higher profits, which provide greater opportunities for development and growth.

4. This, in turn, leads to more jobs and better financial means for the population to spend. Increased spending leads to higher demand for goods and services, which pushes prices up.

Thus, we have the rotation of a healthy inflationary cycle. The final stage of this cycle—employment—is key to prosperity.

There is no problem with prices rising as long as wages also increase, because then you will continue to consume the same goods and services, and everything is fine—the economy will operate normally, it will function well. Prosperity will be shared by all.

Disruption of this normal cycle—such as wages lagging behind the rise in consumer prices—can cause problems. Other factors can also disrupt it. For example, supply chain disturbances during the pandemic led to price increases from some companies, breaking the natural course of the cycle.

What do central banks do? They raise interest rates, which increases the cost of borrowing. This affects businesses, for which it becomes more expensive and difficult to invest, hire staff, and grow. Consequently, the economy slows down. However, this period is challenging for households facing financial difficulties. The fight against inflation also leads to restricted demand.

However, prices may fall instead of rising—that is deflation. Contrary to what one might expect, this is an unfavourable economic condition that leads to a deflationary spiral.

1. When prices fall, consumers may postpone major purchases. Why? Because they hope for further discounts in the coming months. This, however, results in an overall reduction in household spending.

2. When we spend less, companies’ profits become limited.

3. Without funds, companies cut their expenses, leading to staff layoffs and fewer job openings.

4. The unemployed also spend as little as possible. Those who are still employed prefer to save more to prepare for financial losses and hard times. Prices continue to fall or at least remain stable due to low demand, which leads to weak economic growth.

When inflation is high, interest rates rise. In deflationary times, central bankers may introduce negative interest rates in the hope that the economy will eventually recover and inflation will begin to rise.

Deflation is historically rare but difficult to overcome and can take time. The Great Depression is an example of a deflationary spiral, where economic recovery was driven by World War II due to increased defence spending and the resulting creation of jobs in the military industry.

Japan is also an emblematic case of long-term deflation caused by several factors: supply issues, weak demand, and problems in the financial system.

Deflation can negatively impact the economy by discouraging spending and investment because money increases in value over time.

In other words, the cost of deflation is enormous, which is why central banks seek to avoid it. Moreover, if inflation is not around 2% but close to 0%, there is a significant risk of falling into deflation.