You probably know what inflation is and why you might worry about it, but do you know what deflation is? The prospect of falling prices might sound appealing, but deflation can do more harm than good.
Let's review inflation first. It's the increase over time in the cost of goods and services, as defined by the Consumer Price Index. Over long periods, it has averaged about 3% per year. That's just an average, though. There have been times when it has been well into the double digits, and it has been below 2% for most of the past two years.
Using the 3% average, something that costs you $1,000 today might cost you $1,030 next year, $1,061 the following year, and the year after that, $1,093. Three percent might not seem like a lot, but in just three years, that $1,000 item costs almost 10% more. The effect is, of course, stronger over long periods. After 25 years, for example, the $1,000 item is likely to cost around $2,094, more than doubling.
Another way to think about inflation is as the erosion of purchasing power. Assuming a continuation of long-term trends, after 25 years, each of your dollars will be only about 47% as strong as your dollars today. That's a meaningful change, because it means that if you're on a fixed income, receiving $1,000 per month for 25 years, by the end of the period, that income will only be about half as powerful as it was at the beginning of the period.
By contrast, deflation is what you get when prices fall over time -- and at the same time, purchasing power increases. There are some big problems with that scenario, as appealing as it might sound.
For starters, if you think about it, many people will put off buying items if they think prices will be lower in the months or years ahead. As a result, demand drops. When demand is low, companies won't sell as much and will generate less money. (On top of that, they collect less money because of lower prices.)
With businesses making less money, layoffs logically follow, and then unemployment. Once unemployment is rising, wages drop, because job-seekers are willing to accept less. A recession is not far behind. Once serious deflation sets in, it can be hard to get rid of, as Japan can attest. Japan endured about two decades of deflation, and a stagnant economy.
Should we worry?
A deflationary spiral sending our economy south is an ugly prospect. And this past January, inflation in the U.S. dipped into negative territory. Yikes, right?
Well, not necessarily. We don't at this point have a prolonged or severe case of negative inflation. We had several months with negative inflation in 2009 and pulled out of it. In general, our economy is rebounding, with many months of job growth and falling unemployment. Also, a key culprit is obvious: the price of oil has dropped sharply in recent months. That, along with our currently strong dollar, explains much of the drop in our inflation rate. Meanwhile, plenty of products and services have not been falling in price. According to data from the Bureau of Labor Statistics, in the 12 months ending in February of 2015, the price of food, shelter, and electricity each rose about 3%, while all measured items excluding food and energy (which can be more volatile than other categories) rose 1.7%.
Meanwhile, some experts have questioned how damaging a deflationary period would really be for the U.S. as we just haven't had much experience with it. Japan is a useful point of reference, given its prolonged deflationary period, but even there, as Harvard economist Martin Feldstein has noted , "low inflation and periods of deflation did not prevent real incomes from rising in Japan." He also pointed out that, "From 1999 to 2013 [years of deflation in Japan], real per capita gross domestic product rose at an annual rate of about 1%." It's impossible to say exactly how the U.S. would be affected by prolonged deflation, but Japan's example suggests that while it might be unwelcome, it may not be debilitating.
We average citizens don't have much power over inflation or deflation, so it's probably not worth worrying about too much -- at least now, while it doesn't appear to be an imminent threat. It is worth understanding what it is, though, and what it can mean for an economy.
Longtime Fool specialist Selena Maranjian, whom you can follow on Twitter, has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.