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Think falling prices would help? They could destroy an economy. Just ask China

<i>STR/AFP/Getty Images</i><br/>
STR/AFP/Getty Images

By Elisabeth Buchwald, CNN

New York (CNN) — US markets reeled on Tuesday after January’s Consumer Price Index showed inflation came in hotter than expected, leaving investors to believe that interest rate cuts are off the table for the near future.

Markets aside, the data was confirmation that prices are indeed still high and are taking a toll on Americans — just ask anyone who recently got a new car insurance policy (rates are up 21% from a year ago).

China, however, is having a different problem: Prices are falling at their fastest rate in 15 years.

No, that wasn’t a typo, falling prices are a problem when they’re widespread across an economy, like in China, which is experiencing what’s known as deflation.

At first glance, falling prices may sound good. After all, who likes paying more for anything?

But the problem with deflation is that when people begin to expect lower prices in the future, they have little incentive to make purchases right now. For instance, unless it was absolutely necessary, why would you buy a new oven today if you thought the price would go down significantly in a month?

When enough people think that way, it causes massive pullbacks in spending. That can prompt a recession if it means businesses can’t afford to employ as many workers.

In China, the effects of deflation have taken a major toll on stocks, making it the worst-performing equity market in the world last year. That prompted the nation’s sovereign wealth fund to purchase shares of Chinese-listed companies to boost prices.

Additionally, China is pursuing stimulative measures aimed at boosting consumer spending.

Some inflation is good, actually

The surging inflation that Americans and people across many parts of the world have experienced over the past few years, primarily due to pandemic-related factors, is not what central banks want.

Like the US Federal Reserve, most central banks target a 2% annual rate of inflation, not zero inflation whatsoever. That’s done to discourage people from delaying purchases.

It also gives central banks a bit of a cushion against deflation.

“Having a margin against deflation is important because there are limits to how far interest rates can be cut,” the European Central Bank states in a post on its site. “In a deflationary environment monetary policy may not be able to sufficiently stimulate the economy by using its interest rate instrument. This makes it more difficult for monetary policy to fight deflation than to fight inflation.”

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