Deflation is an economic phenomenon involving a generalized decline in the price of a basket of goods and services. in a country or region.
Deflation happens when the annual inflation rate turns negative. Such an event is usually brought about by a reduction in the money supply and/or credit.
It is the opposite of inflation and is therefore often referred to as “negative inflation”. It occurs once the rate of inflation falls below 0%.
Deflation strikes fear into the hearts of central bankers because it’s much harder to fight than inflation, which requires painful but relatively straightforward interest rate hikes.
Falling into a deflationary cycle tends to be extremely negative for an economy and is a development every country tries to avoid.
Deflation prompts consumers to delay purchasing decisions because they expect prices will drop further.
This reduces industrial production and economic activity, depresses business profits, drives down wages, and/or layoffs which increases unemployment.
As prices continue to fall, profits are squeezed further and companies respond by cutting wages further, laying off more employees, which reduces demand for their products and worsens the problem.
It’s a self-reinforcing cycle that can only be broken with massive spending, normally by governments with the help of their central bank.
To avoid this, central banks tend to use different monetary policy tools at their disposal.
For example, following the outbreak of the 2020 COVID-19 pandemic, the major central banks reacted by cutting their interest rates in an attempt to facilitate credit flows and launched massive bond purchasing programs to stimulate inflation by boosting the money supply.
In the forex market, these measures translate into a sharp increase in currency volatility.
Expansionary monetary policies tend to weaken the related currency against the currencies of the main trading partners.
These expansion programs, simultaneously implemented in different countries, lead to sharp fluctuations in the main currency crosses and pose serious challenges to companies exposed to currency risk.