Deflation

Deflation is an economic occurrence characterized by a widespread decrease in the prices of a collection of goods and services within a country or region. It takes place when the annual inflation rate becomes negative, typically resulting from a decrease in the money supply and/or credit.

Deflation is the antithesis of inflation and is often termed “negative inflation.” It occurs when the inflation rate drops below 0%. Central bankers are particularly concerned about deflation because it is significantly more challenging to combat than inflation, which can be addressed through relatively straightforward interest rate increases.

Experiencing a deflationary cycle is generally detrimental to an economy, and it is a situation that nations strive to prevent. Deflation leads consumers to postpone their purchasing decisions, anticipating further price declines. This behavior diminishes industrial production and economic activity, reduces business profits, lowers wages, and can result in layoffs, thereby increasing unemployment.

As prices continue to decline, profits are further pressured, prompting companies to cut wages and lay off more workers, which in turn decreases demand for their products and exacerbates the issue. This creates a self-perpetuating cycle that can only be disrupted through significant spending, typically by governments in collaboration with their central banks.

To avert this scenario, central banks often employ various monetary policy tools at their disposal. For instance, in response to the COVID-19 pandemic outbreak in 2020, major central banks lowered interest rates to facilitate credit flow and initiated extensive bond purchasing programs to stimulate inflation by increasing the money supply.

In the foreign exchange market, these actions result in a notable rise in currency volatility. Expansionary monetary policies generally weaken the associated currency against those of key trading partners. When these expansion programs are implemented simultaneously across different countries, they lead to significant fluctuations in major currency pairs and present serious challenges for companies exposed to currency risk.