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Deflation is a word that is getting a lot of traction of late.  

It is being bandied about in high policy circles as well as in the general population and it is an important factor in the continuing evolution of monetary policy and the transition of the Australian economy from the resources and construction boom.

Deflation can be defined as a general decline in price.

It is in effect the very opposite of inflation where prices rise over time.  Deflation like excessive Inflation is bad for any economy. 

If deflation exists in an economy it can lead to lower consumption as consumers defer purchases into the future.  Consumers figure “why by now?” when you can defer purchases and buy the goods or services in the future at a cheaper price?  

If this thought process takes hold over an entire economy than this can lead to lower economic output and a contraction in an economy; even at a severe level economic depression.

Inflation assists borrowers by making their debt burden reduce over time as the real value of money, and hence the real loan amount, declines over time.   

Deflation has the opposite effect and can lead to an increase in real debt levels.   If this happens in a recessionary period it can lead to massive debt defaults as borrowers are unable to meet their commitments.  

A  modern tenant of central bank policy is “inflation targeting” whereby the bank targets a certain level of inflation in an economy and uses the tools at its disposal – (usually monetary policy – i.e. the level of official interest rates ) – to alter activity in the economy to achieve the inflation target.

Historical Inflation 

Deflation has been a problem in Japan for over two decades since the “bubble economy” of the early 1990’s . The Bank of Japan was the first central bank to attack the problem via a zero interest rate policy whereby it reduced the official cash rate to zero in an effort to entice banks to lend and borrowers to use cheap credit to pump up the economy.   

The end result was not what was anticipated and the economy has performed poorly for nearly 20 years going through bouts of deflation and low inflation. Only recently have the authorities been able to rouse the economy through massive purchases of government bonds (and even intervention in the share market) as it strives to jumpstart the moribund economy.  Its success has been muted and patchy.  

RBA’s dilemma 

The most recent inflation reading for the March quarter for Australia showed negative inflation or deflation for the three months.  The official ABS figurers showed a negative 0.2% reading for the first three months of the year.  This was blamed on lower petrol, food and clothing prices.  The yearly figure stood at 1.3%.   

The RBA targets a 2% to 3% inflation figure and so this latest result was well outside of that range.  It caused the RBA to act on the official cash rate and it lowered the figure to 1.75%. In his message after the meeting Governor Glenn Stevens said;

Inflation has been quite low for some time and recent data were unexpectedly low. While the quarterly data contain some temporary factors, these results, together with ongoing very subdued growth in labour costs and very low cost pressures elsewhere in the world, point to a lower outlook for inflation than previously forecast.

Where has the deflation “come from”?

As usual in the current economic and financial markets situation the answer lies with China.  China has been exporting deflation to the rest of the world for the past decade.   As it has rapidly industrialised and urbanised it has brought hundreds of millions of workers from the country side to the city and become the manufacturing capital of the world.

Its supply chain has lowered the price of everything form smart phones to cars to clothing and these lower prices have enabled us in the west to enjoy a higher standard of living. 

In the local economy the massive slowdown in the resources sector has led to a handbrake on the economy and our output, as measured by GDP, has collapsed.  Large resources projects moving from  the construction phase to the supply phase has seen workforces shrink and large incomes decline as workers move to – or try to move to – other sectors of the economy.

What to does the future hold? 

Unemployment appears to be treading lower but wage growth is very low contributing to the lower inflation levels.   The RBA is likely to cut rates further in coming months; with the market pricing in August as the more likely month, which is after the next inflation reading.  

Our current yearly inflation rate – for the past four quarters – is 1.3% compared to 1.7% for the year ended December.   This is an above average yearly deflation reading but the RBA is vigilant to ensure we don’t head down that path.  It is a path fraught with danger and a nightmare that keeps central bankers awake at night.  

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