Key Takeaways
- Deflation is a sustained decline in prices, increasing consumers’ purchasing power.
- Investors may move assets into cash to preserve capital during deflation.
- Deflation can lower asset prices, impacting stock and bond values.
- Causes include excess supply, low demand, and technological advances.
- Deflation often signals weak economic growth and is harder to control than inflation.
The term “deflation” in macroeconomics refers to decreasing prices. Deflation is the decline in the price of goods and services over an extended period of time.
For investors, deflation’s sustained decrease in prices 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. Deflation’s decreasing prices can lead to decreased investment values, making the relative value of cash more significant, and preferred.
Deflation is concerning because of its impact on economic activity and investors’ decisions. During deflation, investors might consider moving funds away from equities and bonds into cash to preserve capital as asset values decline.
Deflation challenges investor strategies because it affects the performance of stocks, bonds, and cash.
Important
Deflation is not only the opposite of inflation but also different from disinflation, which is a slowing of the growth rate of inflation.
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.
Understanding the 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
Important
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.”
How Deflation Impacts the Economy and Investors
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 as excess 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.
Impact of Deflation on Equity Markets
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. Shares 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).
Deflationary Pressures on the Bond Market
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 as a Safe Haven During Deflation
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
Some economists feel that deflation is more serious than inflation. That’s because deflation, a decline in the prices of goods and services and an increase in purchasing power, is more difficult to control than inflation, a rise in prices for a broad range of products.
For investors, moving money out of stocks and bonds and into cash may make sense during deflation, as the relative value of cash is rising and the preservation of capital may be imperative.
