What Is Deflation and How Does it Affect Investments?

A Look at Deflation's Effects on the Markets

Deflation is commonly defined as a decrease in the general prices of goods and services within an economy. Unlike disinflation, or a slowdown in the rate of inflation, deflation occurs when the rate of inflation actually falls below zero percent, indicating a negative rate of inflation. The result is an increase in the real value of money relative to goods and services.

Quantifying the Rate of Deflation

Inflation and deflation are both measured using a 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 taking the difference between two time periods, dividing it by the earlier period, and multiplying that number of 100 to get a percentage.

As with inflation, measures of deflation can be manipulated by making changes to the components of a Consumer Price Index. For instance, a commodity rapidly falling in price could be artificially excluded from the CPI calculation, even if it's something that consumers must purchase as a part of everyday life. These changes can make it difficult to determine true deflation in some countries.

Food and energy prices are commonly excluded from Consumer Price Index calculations, which can make the measure inaccurate at times. Rapidly increasing energy prices can translate to an under-estimated CPI measure. While food prices tend to be steady in the United States, there are some countries where changes in food prices can have a big impact on true inflation.

Causes of and Solutions to Deflation

Deflation is commonly caused by a fall in aggregate demand (or increase in supply of) goods and services and/or a lack of money supply. When prices react by falling even lower, consumers tend to curb their spending until prices bottom out. Unfortunately, this leads to less production at factories, less investment and a so-called deflationary spiral.

An example of this occurring is the U.S. Great Depression, where the demand for goods fell at the same time saving increased and the money supply was reduced. While such saving would seem positive, deflation can lead to a transfer of wealth away from borrowers (which most people are) and can cause inefficient investment due to confusing pricing signals.

Deflation can be counteracted in a number of different ways, but the methods remain debatable among various economic camps. At its heart, injecting more capital into an economy will generally reverse deflation, since it addresses the only controllable part of the equation. This can be done in many ways, including most recently the so-called quantitative easing approach.

The effectiveness of these approaches is debatable, especially following the U.S. 2008 financial crisis and E.U. 2009 sovereign debt crisis. In general, these programs aim to combat deflation by making it artificially cheaper to borrow money, which may be enough to avoid the "spiraling" tendencies of a deflationary spiral and ideally spur inflation.

Effects of Deflation on Stocks and Bonds

Deflation is generally considered to have a negative impact on stocks, since lower prices over a long time frame tend to hurt bottom-line corporate net income. Moreover, deflation can encourage consumers to save money and reduce their spending, which has a negative impact on top-line revenues, and thereby erode shareholder value.

While deflation is bad for stocks, it can have a positive impact on bonds. Government debt, such as U.S. Treasury Bonds, is worth more because fixed payments becoming increasingly valuable. Interest rates tend to decrease during a deflationary environment, which leads bond prices to increase and bondholders to profit during these times.

That said, deflation is not necessarily positive for corporate bonds, especially those in companies that aren't large blue chip stocks. Deflation makes debt payments more difficult each year, since they become more expensive. This puts companies at risk if they are eventually unable to pay their debts given the lower revenues and profits seen from falling prices.

An especially bad deflationary spiral, however, can be bad for all financial assets. For example, the Great Depression caused a decline in nearly all types of securities as people moved into cash and started to hoard savings due to a mistrust in financial institutions.