One of the main jobs of the Federal Reserve is to monitor the money supply. This means keeping track so that too much money does not flood the system causing inflation. It also means that they must monitor the money supply so that money is not leaving the system causing deflation. Although the economy has been growing steadily for the past few years, the growth in the job market is still struggling. This has caused the Fed continued concern about deflation, and they are keeping a watchful eye on it in case they need to act quickly.
During the Great Recession, many people lost their jobs. The money supply dwindled when the stock market plunged. When the market loses value, that money simply ceases to exist. Without the money, and without jobs to earn money, deflation is a serious risk. In order to counter, the Fed initiates a series of stimulus plans to prop up the money supply and ward off deflation.
The optimum way of maintaining an economy is with slight inflation. This may seem counter intuitive, after all people want the cost of goods to go down. However, deflation is more than just the cost of good dropping. It has serious impacts across the board.
Wages – When the Consumer Price Index shows that the cost of living is dropping, that means a drop in wages will soon follow. Cheaper goods does not mean that everyone can suddenly start living large because their money is going further.
Savings – If the cost of buying a new car today is $20,000 and the cost of buying a new car next year is $19,000 many people will forego buying that car today. In fact, they will often forego investing and saving since hoarding a suitcase full of cash will actually do more for them than putting their money in the bank. Without savings and investments coming in, the banks (which are a major part of the US economy) will struggle.
Borrowing – Deflation is bad for borrowers. Every year that there is deflation, the value of the dollar drops. But the nominal amount owed on the loan will stay the same. So it takes more purchasing power to repay the loan when deflation is happening.
International Trade – Cheaper goods means more countries will hope to buy from the US and exports should do well. But as the US has mostly transitioned from a manufacturing country to a service country, those exports are not as strong as they used to be. Instead, with deflation, it costs more to import the goods needed to survive.
Keeping inflation around 2% is the Fed’s goal. And it is a delicate act to do so. When the money supply dwindles during a recession, deflation rears its head. And while a small amount of inflation is good for the economy, a small amount of deflation is terrible. In order to stave off deflation, money has to be put into the economy, but withdrawn at just the right moment to prevent hyper-inflation. Fortunately, the Fed understands how the money supply works, and has the ability to manipulate it in a way that will help the economy to flourish. Still a little blurry? Check out the great infographic on Mint to get a better grasp.