What Is Economic Deflation?

Definition & Examples of Economic Deflation

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Economic deflation is when an economy experiences declining prices for goods and services. In this regard, deflation is the opposite of inflation, where the cost of goods and services is rising.

What Is Economic Deflation?

Deflation is an economic term that describes an environment of declining prices for goods and services within an economy. Not to be confused with disinflation, or a decrease in the rate of inflation, deflation occurs when the rate of inflation is less than 0%. The Consumer Price Index is the most commonly used means for measuring inflation; if it goes into a negative number, that's deflation.

  • Alternate name: Negative inflation

How Economic Deflation Works

Understanding the economics of deflation can make you a better investor. Deflation can occur in recessions, where demand for most goods and services declines and the providers of these goods and services lower prices to compete for fewer consumer dollars.

In extreme cases, consumers delay purchases in anticipation of further price declines. This can often lead to a self-fulfilling prophecy of lower prices, where consumers expect lower prices and create them by forgoing purchases.

The Great Depression is an example of the result of out-of-control deflation.

A recent example of deflation occurred during The Great Recession of 2007–2008, where the inflation rate fell below 0%. Taken out of context, this might sound like a good thing for consumers, but lower prices are a reflection of lower demand, which arises because lower demand becomes lower revenues, which leads to layoffs and less income for consumers. 

Conditions of the COVID-19 pandemic—where the rate of economic growth in the 2020 second quarter has declined at a record level—could create the same conditions. This will depend on how much delinquent debt is accumulated in the subsequent months in the form of mortgages, student loans, business loans, credit cards, etc. When prices fall it does not mean debt follows. Debt remains fixed or even grows due to compounding interest and missed payment penalties.

Deflation can also be caused for positive reasons—through increased productivity, advances in technology, and new sources of resources or innovation. In this sense, it can be good for an economy because it gives consumers more buying power. The issue is how quickly it occurs.

Tips for Investing in an Economic Deflation

Investing during economic deflation can be challenging—asset prices are falling, causing a loss of interest and value in cash, gold, real estate, and stocks. While these assets generally pay off in an inflationary environment, during a deflationary period they tend to create losses.

Better investments when prices are falling include bond funds, especially long-term bonds, because interest rates are falling and bond prices may, therefore, be increasing.

Certain sector funds that invest in defensive areas such as health care, utilities, staple items, and certain commodities—things people need regardless of economic conditions—can also be good investments during deflationary periods. For example, people still need to go to the doctor, use electricity, and brush their teeth when the economy and stock market are on the downside. This demand generally prevents stocks in these sectors from declining as much as the broader market.

The Federal Reserve exercises monetary policy that works to prevent a deflationary spiral and tries to keep the period from lasting for an extended period of time. Therefore, investments that do well when interest rates are falling can do well during periods of deflation.

Investing Choices in an Economic Deflation
Safer Riskier
Long-term bond funds Precious metal funds
Zero-coupon bond funds Money market funds
Dividend funds (sometimes) Investments dependent on higher prices and interest rates
   
   

There is a risky market timing element when trying to choose the best investments during an expected short-term deflationary environment. Trying to navigate the market and economic conditions with investment strategies is a form of market timing that carries a significant risk of losing value in an investment account. For most investors, building a diversified portfolio of mutual funds is the best strategy for all market and economic environments.

Key Takeaways

  • Economic deflation is when an economy experiences declining prices for goods and services.
  • It can occur in recessions, and become a self-fulfilling prophecy if consumers cut back on spending.
  • Investing in essentials such as health care, utilities, staples, and commodities can make sense.
  • Still, trying to time stock investments in any short-term economic deflationary period can be risky.