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Record price falls lowers inflation outlook – August 2020

The Consumer Price Index (CPI) is an index which measures the general level of prices across the economy by tracking a basket of commonly purchased household items. In the June quarter of 2020, the CPI fell by -1.9%, the largest quarterly fall in the 74-year history of the CPI. This decline in the CPI is what economist term “deflation”.

The COVID-19 economic crisis continues to drag on the economy, despite economic stimulus being injected across multiple fronts through both fiscal and monetary policy (covered in earlier posts). Most of the decline in the CPI can be attributed to three components 1) the introduction of free child care – a discretionary structural cause 2) a fall in automotive fuel prices – a cyclical cause and 3) a fall in pre-school and primary education.

While the current “deflation” is unlikely to trigger a deflationary spiral, it is helpful to understand the dangers of deflation. In a deflationary environment, consumers continue to withhold spending (consumption) with the expectation that prices will continue to fall. This depresses Aggregate Demand (AD) which in turn pushes prices even lower and has the deadly effect of lowering economic activity and increasing unemployment.

Deflationary spirals can be challenging to get out of as conventional expansionary policies become ineffective. For example, Japan entered deflation in the early 1990s because of an asset-bubble crash and it took over 20 years and heavily expansionary monetary policy (quantitative easing) for their economy to see inflation again.

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