A significant decline in commodity prices in recent weeks—coupled with a worsening global economic outlook and major corrections in global equity markets—could result in a Great Deflation, namely a vicious circle of price/asset deflation around the world. The risk of such a scenario occurring is rising as crude oil prices tumbled last week and major equity markets witnessed a significant correction. If these trends continue and unless governments around the world stimulate domestic demand through additional government spending, a Great Deflation is likely to occur and significantly worsen the already weak outlook for the global economy.
Deflation is defined as a generalized decline in prices. It generally leads to slower economic activity as consumption and investment decisions are delayed (household and corporations wait for lower future prices) and an increasing number of borrowers default on their loans as the value of their collateral falls below the loan value. If price deflation is associated with a generalized decline in asset prices, the impact of deflation can be devastating as price and asset deflation feed into a vicious circle of lower income, investment and consumption. The Great Deflation of the 1870s in the UK and the US and the Great Recession of the 1930s provide the best historical examples of such a vicious circle.
We had already warned last August that declining global food prices could increase the risk of global deflation (see our commentary dated August 24, 2014). Since then, energy prices have tumbled, adding to the global deflationary pressures. In particular, the Brent crude oil price has fallen by more than a quarter since its 2014 peak of USD113 per barrel on June 19. Overall, global commodity prices are down 8.3% in the first nine months of 2014 and have fallen further in early October, according to the latest IMF Commodity Price Indices.