Deflation is the decline in the price of goods and services over an extended period of time. For investors, deflation can mean a drop in the value of their investments, such as stocks and bonds.
Deflation is the opposite of inflation, which is characterized by rising prices. And it is different from disinflation, which is a slowing of inflation. (Note: Deflation is different from disinflation, which is a slowing of the growth rate of inflation.)
Some economists feel that deflation is more serious than inflation because deflation is more difficult to control.
Key Takeaways
- Deflation is the broad decline of the prices of goods and services over a period of time.
- The causes of deflation include less money in circulation, a drop in demand, abundant supply, better productivity, and technological innovation.
- Deflation can lead to lower asset prices and investment account values.
- For investors, moving money out of stocks and bonds and into cash may make sense as the relative value of cash is rising and the preservation of capital may be imperative.
- Mild/short-term deflation typically doesn't have a negative effect on stock and bond values.
What Is Deflation?
Deflation is a macroeconomic term that describes the sustained, overall decrease in the prices of goods and services in an economy. As prices drop, consumers' purchasing power increases (which is contrary to what happens in an inflationary environment).
Consumers usually cheer lower prices for the items they buy regularly. However, with time, lower prices can decrease the value of their investments and affect their future financial well-being.
Prolonged deflation can have a detrimental effect on business profitability and ongoing operations. This can have major repercussions for economic activity and growth.
Causes of Deflation
Various reasons can be behind the broad drop in prices that represents deflation. They include:
- Excess supply and low levels of associated demand that prompt companies to lower prices to attract buying
- Advances in technology that cut costs, save businesses money, and translate to lower prices for goods and services
- Less money in circulation, which encourages less spending
- A broad drop in demand for goods and services, and consequently a decrease in spending
According to the Federal Reserve, between fall 1930 and winter 1933 during the Great Depression, the nation's money supply declined almost 30%. In turn, this reduced amount of money in circulation caused an average drop in prices of about 30%. Deflation wreaked havoc. It "increased debt burdens; distorted economic decision-making; reduced consumption; increased unemployment; and forced banks, firms, and individuals into bankruptcy."
Effects of Deflation
During times of deflation, consumer goods and services aren't the only things dropping in price. Investment prices can decrease, as well.
As stocks, bonds, real estate, and commodities fall in value, the relative value of holding cash rises. This leads to less investing, potentially causing further declines in asset prices.
When deflation drags on for too long, companies' profits begin to decline. Economic conditions (such asexcess supply) force companies to sell their products at increasingly lower prices.
Companies may subsequently cut back on production costs, reduce employee wages, lay off workers, and even close production facilities.
If that happens, unemployment will increase, the economy cannot expand, and people won't spend their money because their economic future seems uncertain. A weakened economy is bad news for consumers, workers, businesses, and investors.
In times of inflation, governments curb spending and encourage saving by increasing interest rates.
However, they do the opposite to encourage spending during deflation. But they cannot lower the nominal interest rates to a negative level, or below zero. Central banks in areas affected by deflation can only move the rate by so much.
Equities
During periods of mild inflation, stocks may hold up well. But when the rate of deflation increases, equity prices can begin to decline as people sell off equity investments that no longer offer satisfactory returns.
The stock market can then weaken further, reflected by a dropping price/earnings ratio. Share might start to lose value as company earnings suffer.
Until the government can find a way to increase consumer and business spending, usually by lowering interest rates to stimulate the economy, equity prices will be negatively impacted (though some sectors, such as utilities and healthcare, may maintain price strength).
Bonds
Periods of mild deflation typically don't have a negative effect on bonds. In fact, low level deflation can sometimes be good for bonds of high quality if investors decide to move their money out of stocks in search of investments that they deem less risky (and if they haven't yet decided that cash makes more sense).
However, stronger deflation may also affect the feasibility of bonds for borrowers and investors. Bond prices may rise because corporate borrowers believe paying off their loans will result in financial loss. That's because the money they pay investors will be worth more than the funds they borrowed.
What's more, as interest rates decrease during periods of deflation (to promote more borrowing and spending), bond yields also decline. And if deflation takes hold, the risk of bond defaults can rise.
Cash
During a period of deflation that causes investors to become concerned about the prices of equities and bonds and the declining values of their investment accounts, preserving capital (rather than seeking high yields) can be a paramount goal.
That means moving money to cash from equities and bonds. In addition, deflation makes cash more valuable since typically there is less of it in the money supply.
How Often Does Deflation Occur?
Not very often. In strong, highly developed economies it's rare. When it does occur, it is considered by some to be a sign of extremely weak economic growth.
Which Is Worse Deflation or Inflation?
Generally, deflation is a more worrisome condition. Yes, rising prices that come with inflation can be hard on pocketbooks. But deflation can herald more major economic woes, such as growing economic weakness, recessions, and depressions.
Is Deflation the Same As Disinflation?
No, it isn't. Disinflation refers to a temporary reduction in inflation and occurs as the rate of inflation slows. Deflation refers to a broad drop in the prices of goods and services (and a growth of purchasing power). If disinflation persists, it may lead to deflation.
The Bottom Line
Deflation is a macroeconomic term that refers to the decline of the prices of goods and services and an increase in purchasing power. It is the opposite of inflation, which pertains to a rise of prices for a broad range of products.
For investors, persistent deflation can mean declining asset prices and investment account values. It can prompt investors to seek out the capital preservation offered by cash investments rather than the higher yields of stocks and bonds.
