Deflation risk is now a worry even for China

Deflation isn't just about football
Deflation isn't just about football

The specter of deflation has settled over vast tracks of the global economy, forcing countries large and small to assess the risks of falling prices.

Major economies such as Japan, Germany, the United Kingdom and the United States are all experiencing ultra-low inflation or outright price decreases. Emerging markets like Thailand are under pressure. Deflation is widespread across Europe, and prices have been sliding for years in trouble spots like Greece.

Now the alarm has spread to China. The People's Bank of China slashed interest rates at the weekend to keep prices from weakening too quickly.

"[The central bank] has clearly become more concerned about deflationary pressure in recent weeks," said Tao Wang of UBS. Inflation is now running at 0.8% in the country, a five-year low.

What's so bad about paying less for stuff? Consumers are right to cheer -- so long as their country is experiencing "good deflation." In places where price declines have been driven by falling energy prices, for example, people can save a little more or spend a little more.

Technological advances can also result in price reductions. Flat-screen TVs or cameras, for example, are much cheaper now than just a few years ago. For the same price, customers walk away with much improved products.

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But economists are worried about something more sinister: The prospect that a harmful deflationary cycle could develop at a time when central banks are running out of ways to respond.

If households and businesses expect prices to stay depressed for a long period, they may postpone spending and investment, triggering a downward spiral in economic activity and prices. Deflation also makes it harder for countries to pay off debts, and can force weak economies to cut wages to compete globally.

Central banks would typically fight this cycle by slashing interest rates and pursuing other stimulus measures. But many have already cut rates as low as they can as they seek to recover from the global financial crisis.

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In Europe, investors are so nervous that they are essentially paying for the privilege of lending money. The idea is that should deflation take hold, government bonds with negative yields may be a safer bet than other assets.

The European Central Bank is about to start buying 60 billion euros of bonds a month, and that has driven yields lower. It hopes banks and investors will be encouraged to seek higher returns elsewhere, by lending or investing in companies.

There is no panacea: Policymakers in Europe, for example, face interconnected problems, but anti-deflation policy prescriptions vary from country to country.

The problem, though, is now squarely at the front of the global agenda.

"Monetary policy has a limited effect in a serious deflationary environment," Scott Wren, an equity strategist at Wells Fargo, wrote last month. "Even with interest rates at virtually zero, demand for credit is not robust as numerous central banks around the world are now learning."

It's official: America has deflation

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