What is deflation and what does it mean for you?

Theres a lot of talk about potential deflation at the moment, especially in the eurozone.

If deflation does happen, it could bring the current economic recovery to a halt, and hit share prices.

Here, I explain what deflation is, the chances of it actually happening, and how it would affect you.

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Transcript

A quick definition: deflation is when prices fall; perhaps for more than just one month, but persistently for a period. That sounds great in many ways - we all like falling prices, and we all like a bargain. But it does have at least one damaging economic consequence. Deflation is bad news, not good news.

The big problem with deflation is that the real value of debts grows.

Let's say you owe £100,000 to the bank, and we get deflation where prices are falling 2% a year. The bank won't suddenly say, "Great. We're going to cut the value of your debt from £100,000 to £98,000." No, your debt is still £100,000. Of course, the real value - the inflation-adjusted value - of that debt, is now rising.

That's bad news for you as an individual. It may mean that you spend less; or that you'll be less confident about life and about your finances. There's an increased chance of you going bust.

It's just as damaging for businesses. Businesses, if they owe debt, may reduce investment, lay off staff, generally pull in their horns, or even go bust. There's no doubt about it; deflation is bad news for people with debts. That's the real negative consequence.

The second issue that people often talk about with deflation is perhaps a bit more controversial. It's the idea that deflation will reduce consumption across an economy.

Let's say you're about to buy a new car for £20,000. If you then discover that that new car will be available for £18,000 in six months' time, you might decide to wait and buy the new car when it's cheaper. That'll reduce consumption, and then prices will keep falling. You'll get a vicious circle of falling demand.

That's the theory. I'm not 100% convinced, simply because we've had deflation in electronic goods for the last ten years. For things like TVs and computers, prices have been falling. If I wanted to buy a new computer now and the price was £500, even if I knew for sure that that price would be £450 in six months' time, I'd still buy the computer now because I need it now.

This second consequence of deflation is more controversial. It may be true, it may not be. I'm sitting on the fence.

What I'm sure about is that deflation overall is bad news. If you're not convinced, just look at Japan. Since the early '90s, Japan's been going through periods of very low inflation, then into deflation, then very low inflation again, then into deflation. Over that period, we've had sluggish economic growth in Japan and very disappointing stock market performance.

We could have an argument about cause and effect here, about the chicken and the egg; which came first? What's very clear is that in times of deflation, times are hard, and economies perform badly. When you see that association, that performance happening, I think it's best to avoid deflation.

When we get back to 2008 and the financial crisis, one of the reasons that policymakers were so worried is they thought we could be heading into deflation if things carried on being so bad. That could lead to a 20-year economic slump, an economic malaise like we've seen in Japan.

When the central bankers were so worried, their first policy weapon was to lower interest rates as far as they could go. That way, they stimulated the economy. That's fine, but of course, inflation got very low, too.

If inflation's 1% and interest rates are 0.5%, then real' interest rates aren't as low as you think, and there isn't such a big economic stimulus. That's known as the liquidity trap: if you can't cut interest rates any lower, below 0%, the impact of low interest rates is lower than you might expect.

That's why, because of the liquidity trap, we had quantitative easing (QE) - money printing. What policymakers were very aware of is that the problem of the liquidity trap would get even worse if we got into deflation.

Imagine if the interest rate is 0.5% and prices are falling at 2%. In reality, interest rates are rather high, even if they don't look that way at first glance. That's another sign of how damaging deflation can be. It can make life very difficult for policymakers, for governments, and for central bankers. That's why they try to avoid it.

In 2014, deflation has come back onto the agenda. Inflation has fallen to its 2% target in the UK. In Europe, inflation's a lot lower, and some people are concerned we may see real deflation.

My view is that it's not likely, but it is possible. I don't think it's likely because when you look at the world as a whole, the global economy is growing. There's too much growth there, too much excitement, to see a real fall into deflation. It's not likely, but you can't rule it out in Europe.

The worry that it could happen in Europe means interest rates will stay very low in Europe for some time. We may see some more policies that are similar to QE or money printing.

Even in the UK, concerns about low inflation - or even the small chance of deflation - mean interest rates will stay lower for longer. Of course, low interest rates are great for stock markets. More money printing is great for stock markets. Basically, the fact that deflation is back on the agenda is good news for investors.

That's a quick roundup on deflation. I hope you found it useful. We'll be back with another video soon.