What Is Deflation?

Definition & Examples of Deflation

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Deflation is a decrease in the general prices of goods and services within an economy. Unlike disinflation (a slowdown in the rate of inflation), deflation occurs when the rate of inflation becomes negative, indicating a gain in currency purchasing power.

Learn more about deflation, how it occurs, and its effect on stocks and bonds.

What Is Deflation?

Deflation is an increase in the real value of money relative to goods and services. This means you can purchase more with $1 in a negative inflation economy than you could in a positive inflation economy. Inflation and deflation are both measured using the Consumer Price Index (CPI), which measures the prices of a selection of goods and services purchased by a typical consumer over time.

The rate of deflation can be calculated by doing the following:

  1. Subtract the price index of the current year (CPIc) from the price index of the previous year (CPIp).
  2. Divide the result by the previous period's CPI.
  3. Multiply the result by 100 to get a percentage.

(( CPIc - CPIp ) / CPIc ) * 100 = Deflation Rate

How Deflation Works

Deflation is commonly caused by a fall in aggregate demand (or an increase in supply) of goods and services or a lack of money supply. If consumers reduce their spending, demand becomes less, causing supply to go up and prices to go down. Investors see prices falling and begin to sell. Panic ensues, and the market nose-dives.

Consumers tend to curb their spending even more until prices bottom out, which compounds the problem further.

Deflation can be counteracted in several different ways, but the methods remain debatable among various economic camps. Injecting more capital into an economy will generally reverse deflation since it addresses the only controllable part of the equation: money supply. Most recently, the Federal Reserve introduced quantitative easing.

The quantitative easing approach was conducted by cutting the federal fund rate—the interest rate banks charge each other for overnight loans—and purchasing a large number of long-term bonds, decreasing the value of bonds in an attempt to increase inflation.

The effectiveness of an unconventional monetary policy, such as quantitative easing, is still being debated, though. In general, policies such as these aim to combat deflation by decreasing the dollar's value by increasing the money supply or decreasing the value of bonds.

Notable Happenings

Deflation is generally considered to have a negative impact on stocks since lower prices over an extended timeframe tend to hurt bottom-line corporate net income. Moreover, deflation can encourage consumers to save money and reduce spending, negatively impacting top-line revenues, and eroding shareholder value.

While deflation is bad for stocks, it can have a positive impact on some bonds. Government debt, such as U.S. Treasury Bonds, is worth more because fixed payments become increasingly more valuable. Interest rates tend to decrease during a deflationary period, which leads to increases in bond prices and profits for bondholders.

Deflation isn't necessarily positive for corporate bonds, especially those in companies that aren't blue-chip stocks. Deflation makes debt payments more difficult each year since they become more expensive. This puts companies at risk because they eventually will be unable to pay their debts.

Pros and Cons of Deflation

  • Lower prices

  • Cheaper to borrow money

  • Shrinks wealth gap

  • Lower wages for workers

  • Unemployment increases

Pros Explained

  • Lower prices: When deflation occurs, consumers spend less money, which drives down demand. This drop in demand and increase in supply leads to a decline in prices because businesses have to lower prices to get the inventory gone.
  • Cheaper to borrow money: As a way of combating deflation, the Federal Reserve will typically lower interest rates to encourage people to spend more and invest less in fixed-income investments like bonds. The low interest rates also mean people can borrow money for much cheaper, which is extremely helpful for things like mortgages.
  • Shrinks wealth gap: The value of most assets falls during deflation, and wealthier individuals are more like to hold assets than cash, so they experience a more significant loss compared to lower-income people, who benefit from the increased value of the dollar.

Cons Explained

  • Lower wages for workers: As consumers start to spend less money, businesses lose money, and these drops in profit mean they don't have as much to pay employees.
  • Unemployment increases: An increase in supply means that companies have to start reducing the production of goods. Cutting down production means they have to begin to layoff employees and, in some cases, permanently close factories or stores. This not only hurts current workers, but it limits employment opportunities for people entering the workforce.

Key Takeaways

  • Deflation occurs when the value of the dollar increases and the cost of goods and services drop.
  • Deflation can cause increased unemployment and wage drops.
  • Wealthy individuals experience more significant losses during deflation because assets are more likely to decrease in value.
  • The Federal Reserve tries to slowdown deflation by increasing the money supply and encouraging spending.