The Impacts of Deflation on Zara

Word Count: 922

To:         Inditex Upper Management

From:         Team 5

Re:         The Impacts of Deflation on Zara[pic 1]

 Deflation, simply put, is a general decline in prices. The fall in price level may, at first, seem to be a positive signal, especially from the consumer’s point of view. However, the main cause of widespread deflation in an economy is in fact due to a sustained fall in demand and output. It is a situation where in the demand falls significantly, and in an attempt to stimulate spending, firms start to cut prices. Other causes of deflation include a reduction in the money supply or credit in the economy. When an economy is experiencing deflation, the purchasing power of a single unit of money increases. This means prices of all goods and services start experiencing a downward pressure. This affects a number of aspects in the economy. Consumers might think that prices are going to fall even further tomorrow, and therefore choose not to spend money today. This pushes the economy into a downward spiral, causing high level of unemployment and potentially pushing the economy into depression. Although deflation is a rare occurrence, it is a phenomena that has been witnessed time and again – the Great Depression being one of the most financially trying times in American history.

The last couple of years have been marked with low inflation rates for the Euro region. This falling Eurozone inflation has led to speculation that the region could potentially fall into a Japanese-style deflation trap. Greece is already experiencing deflation. In Spain, inflation dropped to 0.3% in January 2016, after being flat in the previous month. The cause of this is multifold. Unemployment in Europe has increased since the 2008 meltdown. This puts a downward pressure on wages and acts as a big factor in keeping inflation levels low. Also, several European economies have been practicing what is called “fiscal austerity”, wherein they focus on reducing their budget deficits. This leads to an increase in taxes and thus, reduces the demand in the economy significantly. However, this low level of inflation since early 2013 can only be partially attributed to the developments in prices of energy goods (prices of oil reached an 11-year low in December) and unprocessed food. The other components of the Eurozone consumer price index (non‐energy industrial goods, processed goods, and services) have also been characterized by subdued dynamics, supporting the view that weak aggregate demand was playing a key role in keeping inflationary pressures subdued.

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Source: European Central Bank

The European Central Bank (ECB) has since engaged in a number of policies in recent times clearly demonstrating that they are worried about demand in the economy. In January 2015, Mario Draghi, President of the ECB, announced a €60bn-a-month asset purchase program. This was followed by an unprecedented monetary policy stimulus through massive bond purchases, and extremely low long term funding rates to banks in order to aid the economic recovery. The bank also applied negative rates to certain deposits held by commercial banks at central banks (usually applied to excess reserves) in order to fight off deflation. ^[1] The idea of negative interest rates is that commercial banks are discouraged by parking funds in the central bank and instead loan the money out, which would stimulate the economy. Despite these policy measures and accommodating stance, inflation has been anemic, while there has been deflation as well. The ECB has an inflation target of 2% and they have not come close to achieving this target despite their best efforts. Going forward, although the Eurozone is not expected to return to the deflation stage, it will still be experiencing low levels of inflation. The Eurozone economy remains at a critical juncture and a combination of risks, both domestic and external, are looming over the medium-term horizon.