Deflation is the inflation process in reverse. That is, wages and prices spiral downward in tandem, as a deflationary psychology sets in among businesses and consumers. Wage growth always slows in a recession, and the longer unemployment stays high, the greater the slowdown.
The Federal Reserve's increasingly unconventional efforts to mend the financial markets and restore economic growth are starting to take on a new urgency. Recent data indicate the economy's descent into recession is accelerating, and the risk of a debilitating bout with deflation is rising--slack demand, rising joblessness, frozen credit and vanished home value all are feeding a vicious spiral.
That combination, as seen in the U.S. in the 1930s and in Japan in the 1990s, is fuel for deflation---which is sure to be a hot topic in the coming months.
The Fed will now concentrate on pumping money directly into the economy by purchasing "large quantities" of mortgage and other asset-backed securities. The efforts are meant to cut borrowing costs and kick-start demand. As falling energy prices push inflation below zero in 2009, news reports are sure to feed deflationary psychology the same way energy's influence on inflation in 2008 prompted expectations of rising prices.
Source: BUSINESSWEEK, December 29, 2008