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 (a slowdown in the rate of inflation), deflation occurs when the rate of inflation becomes negative, indicating a gain in currency purchasing power.

The result is an increase in the real value of money relative to goods and services. What this means is that you can purchase more with one dollar in a negative inflation economy than you could in a positive inflation economy.

Don't wish for a deflating economy just yet—it is bad situation for businesses. Profits begin to decrease, causing employee layoffs and budget cuts. Consumers have less money to spend, and businesses have fewer customers. Investors have less capital to finance businesses—it is a vicious downward spiral in an economy that is hard to recover from.

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 spending, negatively impacting top-line revenues—thereby eroding 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 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 (stocks in large, well-established companies with dependable earnings). 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.

A deflationary spiral that is not dealt with can be devastating for an economy. For example, the Great Depression caused a decline in nearly all types of securities as people moved to cash and started to hoard savings.

Causes of and Solutions to Deflation

Deflation is commonly caused by a fall in aggregate demand (or an increase in supply) of goods and services, and/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. Unfortunately, this compounds the problem further.

Deflation can be counteracted in a number of 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. Most recently, the Federal Reserve introduced quantitative easing.

Putting on the Brakes

Put very briefly, 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 (remember bond value generally increases with deflation), 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. In general, policies such as these aim to combat deflation by decreasing the value of the dollar by increasing the money supply or decreasing the value of bonds. This is thought to be enough to avoid the tendencies of a deflationary spiral to continue (essentially stepping on the brakes), spurring inflation.

Quantifying the Rate of Deflation

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 subtracting the price index of the current year (CPIc) from the price index of the previous year (CPIp), then dividing the result by the previous period's CPI. Multiply the result by 100 to get a percentage.

(( CPIc - CPIp ) ÷ CPIc ) x 100 = Deflation Rate

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 can be excluded from the Consumer Price Index. This version is known as the CPI for All Urban Consumers: All Items Less Food and Energy, which takes into account that food and energy prices are more volatile than other consumer goods.

Using the CPI without food and energy results in a more accurate measure of consumer behavior. Using this measure instead of the CPI All Items can give you a more accurate determination of the deflation rate, and therefore a better picture of the effect on investments.