It’s old news that the last three months haven’t been what the global economy expected. The IMF forecasts that US economic growth will fall to -5.9% in 2020, and there’s ample speculation around just how bad the current recession will be. Inflation and deflation are tied to recessions because less economic activity, meaning lower demand for goods and services, leaves companies with surplus goods. To make up for the excess in supply and stimulate demand, they’ll deflate the prices. In order to understand how this recession with impact your wallet, you’ll need to understand the relationship between inflation and deflation during a recession.
What is a Recession?
A recession is a significant decline in economic activity and is officially defined as two consecutive quarters of negative growth in the economy. A recession can last anywhere from six months to more than one year. Falling gross domestic product (GDP), industrial production, real income, wholesale-retail sales, and rising unemployment are all potential indicators of a recession.
What are Inflation and Deflation?
Inflation is a term used to describe a general increase in the overall price level of consumer goods and services in the economy. When the opposite of this happens, deflation appears as a general decline in prices. Deflation occurs only when price declines are so widespread that broad-based indexes of prices, such as the consumer price index, register ongoing declines. The effects of deflation can include mass layoffs and increased financial stress.
How Are Prices of Consumer Good and Services Evaluated?
Economists and Policymakers evaluate how the prices of products and services fluctuate with the Consumer Price Index (CPI). According to the Bureau of Labor Statistics, CPI is a tool that measures “the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.” By measuring the prices in the major categories of consumer spending, including food and beverages, housing, medical care, transportation, energy, and other commodities such as recreation and clothing, the CPI takes a cohesive look at how those costs change over time.
The most recent publication of the Consumer Price Index in the United States seems to confirm the fears of economic analysts on the impact of the economic recession on the price level. The “Great Confinement” first generated a dramatic drop in energy prices, a slight drop in the overall price level for the first time since the 2008 recession.
CPI Usage Example: The Great Depression
An example of the consumer price index in action occurred following the Great Depression. In the late 1920s and 1930s, the weakening economy led to a general downward trend in the prices of goods and services.
During The Great Depression, prices as a whole dropped, as unemployment increased and wage growth slowed. Due to these factors, household consumption decreased and sales fell. This was a classic case of deflation. The below chart shows how the consumer price index reflected these shifts.
What Does the Consumer Price Index Tell Us Now?
Although we can see that during the Great Depression price indexes fell considerably, the same could not be deduced about the price reduction during this recession. The price trend measured by the U.S Bureau of Labor Statistics during April 2020 is not homogeneous enough.
Despite energy prices decreasing -10.1%, food prices increased by 1.5%, and medical services prices grew by 0.5%.
Thus far, the consumer price index does not yet demonstrate deflation across the board.
What About Core Inflation?
While the consumer price index tells us plenty in relation to inflation’s impact on a recession, it’s also important to look at core inflation.
Core inflation, introduced in the 1970s by economist Robert Gordon and commonly used by policymakers and economists, evaluates underlying inflation. It discards the records corresponding to energy and food from the basket of goods registered in the index, due to the seasonal and volatile nature of their prices. When discounting these components, prices in the United States in April fell for the second consecutive month -0.4%, after the 0.1% drop in March, a phenomenon that had not occurred in 37 years.
What Might Happen During This Recession?
While there’s been a fall in the inflation rate, the depth of the downturn could lead to deflation. Since the fiscal response involved a strong monetary policy to stimulate the economy, inflation has the potential to decrease in the medium term. Time will tell how the economy shifts amid various social and political pressures.
If you’re wondering how this may impact your wallet, the best thing to do is not panic! While prices may continue to fluctuate, take a look at your finances, and start planning the next steps to be prepared for the future. If you are wondering how you should adjust your budget due to the recession, finding the right advice can help. Make sure to schedule a time and speak with your financial advisor about how inflation may impact your financial plan.
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