Navigating the Inflation-Deflation Balance: Understanding the Economic Cycle

In 2022, much of the world experienced a period of unusually high inflation, with the U.S., U.K., and Eurozone all peaking around 10%. This meant that prices were, on average, 10% higher than the previous year. For many, this surge in inflation was a significant source of stress, with consumers feeling the pinch and businesses struggling to adapt. Although inflation has since moderated and is closer to typical levels, prices have not decreased; they have merely stopped rising as rapidly. This persistent increase in the cost of living continues to burden consumers and businesses alike.

Despite the negative impact of rising prices, experts and financial institutions often claim that “a little inflation is a good thing.” The reasoning behind this is tied to economic growth and stability. Governments and central banks typically pursue an “inflation target,” commonly set around 2%, to foster a “virtuous cycle” in the economy. This cycle encourages consumer spending, as people are more likely to purchase durable goods, such as cars and appliances, in anticipation of future price increases. This spending, in turn, drives business revenues, job creation, and economic demand, thereby sustaining higher prices.

However, this cycle only remains virtuous if wages rise alongside prices. In the U.S., for two years, wage growth lagged behind inflation, causing financial strain for many households. Since mid-2023, wage growth has begun to outpace inflation, especially for lower-income workers, which is a positive development. Nonetheless, wages are still considered insufficient by many, highlighting the need for further improvements.

Disruptions to this economic cycle, such as supply chain issues or opportunistic price hikes by companies, can transform it into a “vicious cycle,” leading to the kind of high inflation seen in recent years. Central banks often respond by raising interest rates, making borrowing more expensive and slowing economic growth. This was the approach taken by the U.S. Federal Reserve in 2022, which helped to reduce inflation but also increased financial pressure on families who rely on borrowing.

Conversely, when prices fall, a phenomenon known as deflation can occur, potentially leading to a “deflationary spiral.” In this scenario, consumers delay purchases in anticipation of further price drops, reducing overall spending and causing companies to cut costs and lay off workers. This reduction in spending and employment further depresses prices and economic growth, making deflation difficult to counteract.

Historically, deflation has been rare but severe when it occurs, often requiring substantial economic interventions to reverse. The Great Depression and Japan’s decades-long struggle with deflation are notable examples. To avoid these scenarios, central banks aim to maintain a low but positive rate of inflation, ensuring economic stability and preventing a slide into deflation. This delicate balance underscores the complexity of managing inflation and the importance of understanding its role in the broader economy.