Is Deflation Bad for the Economy?

Inflation is and has been a highly debated phenomenon in economics. Even the term "inflation" has different meanings in different contexts.

Many economists, business people, and politicians maintain that moderate inflation levels are needed to drive consumption, assuming that higher levels of spending are crucial for economic growth.

The Federal Reserve typically targets a low rate of inflation for the long-run, believing that slowly increasing price levels keep businesses profitable and prevents consumers from waiting for lower prices before making purchases. There are some, in fact, who believe that the primary function of inflation is to prevent deflation.

Others argue that inflation is less important to the well-being of the economy and even a net drag on it. Rising prices make it harder to save money, driving individuals to engage in riskier investment strategies to increase or just maintain their wealth.

Some claim that inflation benefits some businesses or individuals at the expense of others.

Note: The Social Security Administration's cost-of-living benefit increase for 2025 is 2.5%.

Understanding Inflation

Inflation is a term often used to describe the impact of rising oil or food prices on the economy. For example, if the price of oil goes from $75 a barrel to $100 a barrel, input prices for businesses will increase and transportation costs for everyone will also increase. This may cause many other prices to rise in response.

However, most economists consider the actual definition of inflation to be slightly different. Inflation is a function of the supply and demand for money, meaning that producing relatively more dollars causes each dollar to become less valuable, forcing the general price level to rise.

The Impact of Inflation

The primary impact of inflation is on purchasing power, which it erodes over time. The same amount of money buys less and less as prices rise.

Though individuals may receive cost-of-living adjustments to their wages, they more commonly pay out more of their income on the groceries they buy, the rent they pay, and other transactions they conduct.

The Fed's Response to Inflation

When inflation goes up over a sustained period of time, the Federal Reserve's monetary policy often calls for raising the federal funds rate to rein in its pace.

A higher fed funds rate makes borrowing more expensive and less attractive to businesses and individuals. If you use credit cards, you may have seen the increase affect credit card rates.

Less borrowing usually means less spending. Companies often sell fewer products. That, in turn, leads to a slower economy, which should slow down the pace of price rises. However, a slowing economy may also lead to diminished corporate profits, layoffs, and income pressures on households.

The end result of this cycle of events potentially can be a recession. For that reason, the Federal Reserve tries hard to balance the need to stem inflation with the need to maintain acceptable levels of unemployment.

Benefits of Inflation

When the economy is not running at capacity, meaning there is unused labor or resources, inflation theoretically helps increase production. More dollars translates to more spending, which equates to more aggregate demand. More demand, in turn, triggers more production to meet that demand.

British economist John Maynard Keynes believed that some inflation was necessary to prevent the Paradox of Thrift.

This paradox states that if consumer prices are allowed to fall consistently because the country is becoming too productive, consumers learn to hold off on their purchases to wait for better deals. The net effect of this is to reduce aggregate demand, leading to less production, layoffs, and a faltering economy.

Economists once believed an inverse relationship existed between inflation and unemployment, and that rising unemployment could be fought with increased inflation. This relationship was defined by the famous Phillips curve. The Phillips curve was somewhat discredited in the 1970s when the U.S. experienced stagflation.

Who Benefits?

Inflation makes it easier on debtors, who repay their loans with money that is less valuable than the money they borrowed. This encourages borrowing and lending, which again increases spending on all levels.

For example, if a debtor has $10,000 of debt during an inflationary period, that debt has less worth as time progresses. From a purchasing power standpoint, it's more advantageous to slowly pay off this debt during highly inflationary periods due to the debt's diminishing value.

• Homeowners who have long-term, fixed-rate mortgages may benefit from inflation. As inflation rises, the outstanding mortgage's value declines. As a result, the pace of repayment can increase.

• Because of the slowing economy and risk of recession, individuals who have job tenure or are in more secure positions often benefit. People in positions of less demand or startup departments/companies are more at risk from corporate budget cuts.

• When a nation's inflation rate rises, the purchasing power of its currency often weakens against other international currencies. Those owning foreign currency then can take advantage of potentially favorable exchange rates.

When Inflation Is Bad

Inflation can signal trouble for the economy and consumers. Consumers face rising prices, decreasing purchasing power, and an escalating risk of layoffs. This is especially true for those who do not receive salary or wage increases that keep up with the cost of living.

Consumers trying to make large purchases may be priced out of the market when inflation is high. As mentioned, when the Federal Reserve raises rates, the cost of debt usually increases. This can stop many prospective homebuyers from searching for a new home because they may not be able to afford the higher monthly payments.

Inflation is also bad for consumers with certain fixed economic contracts—for example, workers who have fixed-term, temporary contracts that do not allow for wage increases.

The same goes for investors with fixed-income securities, especially longer term bonds. The rising interest rates associated with inflation decrease the value of bonds held in a portfolio. Selling them would result in a loss. So unless they have short terms or they're being held to maturity, bonds with fixed interest rates usually will be less attractive to investors during periods of inflation.

Social Security Benefits

Retirees face major challenges as inflation erodes the purchasing power of their monthly Social Security benefit payments. These payment amounts don't change and may represent the only income many retirees receive.

To combat this deleterious effect, the Social Security Administration (SSA) increases benefits annually using its cost-of-living adjustment (COLA). Unfortunately, benefit increases often lag the inflation rate, so retirees must absorb price increases, which means they'll have to do with less.

In 2025, Social Security and Supplemental Security Income (SSI) benefits will increase by 2.5%.

The Bottom Line

During inflationary periods, some parties benefit while others face increasing financial risks. For many, inflation can be frightening, given its ability to erode purchasing power. For others, inflation is necessary to grow the economy. The Fed continues to maintain its 2% target for inflation.