Sarnia Lambton Chamber Of Commerce - First Monday

First Monday - September 2009

The Tug of War Between Deflation and Inflation

The article below is an executive summary from a series of independent research reports written by Tina Kremmidas, Chief Economist at the Canadian Chamber of Commerce on key public policy issues facing Canada today. The summaries can be found at www.chamber.ca/images/uploads/Economic_Series_-_Summaries.pdf. The papers are designed not to recommend specific policy solutions, but to stimulate public discussion and debate about the nation’s challenges. The full reports are available at www.chamber.ca. ~ G. McDonald.

The global recession that ensued from a massive financial crisis and acute loss of confidence has been unprecedented both in terms of its severity and high degree of synchronicity. Worldwide, demand slumped and trade plummeted resulting in a considerable degree of economic slack that has kept downward pressure on prices. Headline inflation has fallen dramatically in advanced economies, and in many countries it has dipped below zero.

Total inflation in Canada - measured in terms of the rate of change in the Consumer Price Index (CPI) year-over-year - has declined sharply, and in June fell into negative territory. Excluding the most volatile components of the Index¹, the core rate of inflation has remains well anchored and in-line with the Bank of Canada’s operational target (1 to 3 percent).

Deflation concerns are growing as consumer prices shrink. Deflation is defined as a sustained drop in the general level of prices as measured by an index of consumer prices. This decline affects most (if not all) prices in the economy, and is entrenched in expectations. Deflation should not be confused with disinflation, which is a slowing down in the rate of price increases. Conversely, inflation is a persistent rise in the average level of prices.

To combat the risk of deflation, central banks around the world (including the Bank of Canada) have aggressively cut interest rates to stimulate aggregate demand. Central banks also introduced bold and innovative measures to provide the market with much needed liquidity to kindle the flow of credit. Governments have committed substantial fiscal stimulus focused on spending and targeted tax cuts.

This massive fiscal and monetary stimulus has led many observers to warn that rampant inflation, not deflation, is what we need to fear once economic recovery takes hold.

The tug of war between deflation in the near term, and rampant inflation down the road, is still very much in question. We believe neither will materialize in Canada.

¹Fruit, vegetables, gasoline, fuel oil, natural gas, mortgage interest, intercity transportation, and tobacco products as well as the effect of changes in indirect taxes on the remaining components.