When prices fall, that sounds like a good thing for consumers. Cheaper goods, more purchasing power — what is not to like? But economists fear deflation, often more than they fear moderate inflation. This seems counterintuitive until you understand the mechanisms that make falling prices dangerous.
The central problem is the deflationary spiral. When prices are falling, rational consumers delay purchases: why buy a television today if it will be cheaper next month? This logic applies across the economy simultaneously. If everyone waits to spend, demand falls. Falling demand forces producers to cut prices further to sell their goods. Cutting prices means cutting costs — wages, jobs, investment. Lower wages and unemployment mean less spending. Prices fall further. The spiral feeds on itself.
Japan experienced this dynamic during its "Lost Decade" of the 1990s and into the 2000s. Property and equity prices collapsed in the early 1990s. As deflation took hold, consumers and businesses delayed spending, investment collapsed, and the economy stagnated for decades despite interest rates being cut to zero.
Deflation also makes debt more burdensome. If you owe £100,000 on a mortgage but the value of your home falls by 20%, you owe more than the asset is worth. Meanwhile, the real value of your debt increases — £100,000 buys more in a deflationary environment than when you borrowed it. Rising debt burdens force households to cut spending, deepening the slump.
Deflation also cripples monetary policy. When interest rates are already near zero, there is little room to cut further. In a deflationary environment, even zero nominal rates can imply positive real rates (nominal rate minus inflation), keeping borrowing expensive in real terms.
This is why central banks target positive inflation rather than price stability at zero. A small, predictable amount of inflation greases the wheels of the economy. Deflation, by contrast, can grind them to a halt.