Deflation: Definition, Causes & Economic Impact

Deflation Definition

Deflation is a decline in the general price for goods and services over time. This decrease in prices results in an increase in consumer purchasing power, meaning that consumers can buy more goods and services with the same amount of money.

Extended periods of deflation are not common in U.S. history, with only two major occurrences in the past 100 years: One during the Great Depression during the 1930s and the other in the Great Recession from 2007 to 2009. In other countries, Japan’s deflationary period in the 1990s, or “Japan’s Lost Decade,” is notable in historical context.

Deflation vs Inflation

The opposite of inflation, deflation can indicate recession, whereas inflation generally indicates an overheated economy. While inflation can be described as too many dollars chasing too few goods, deflation is associated with a contraction in money supply.

How Deflation Works

Deflation can occur in an economy when consumer and asset prices are falling over time. While lower prices result in more purchasing power for consumers, a spiral downward in prices occurs when consumers delay purchases, hoping to buy goods for a lower price at a later date.

When consumers delay purchases, the supply of goods can remain high, as lower spending results in less income for the producing businesses, leading to higher unemployment, which can result in a negative feedback loop of even lower prices, thus more deflation and less spending. When deflation leads to more deflation, severe economic consequences follow.

What Causes Deflation

There are two primary causes of deflation, or decline in the general price of consumer goods and services over time: a decline in aggregate (total) consumer demand and an aggregate increase in supply. These primary deflationary causes are often the result of various contributing related factors.

1. Decline in Consumer Demand

A decline in consumer demand often results in declining prices, which is a deflationary environment. Some potential contributing factors for a decline in consumer demand is a reduction in government spending or rising interest rates. When interest rates are higher, consumers may save more of their money and borrow less, which means less spending.

2. Increase in Supply

An underlying factor of an increase in the supply of goods can be increases in economic output. This type of increase has historically come from advances in productivity arising from advances in technology, which can increase production and lower production costs at the same time. If output exceeds consumer demand, the price of goods can decline.

Impact of Deflation on the Economy

Deflation can have a wide range of negative effects on the economy as a whole. More specifically, deflation has unique impacts on consumers, businesses, and investors.

1. Impact of Deflation on Consumers

The short-term impact of deflation on consumers can be positive, as falling prices for goods and services translate into an increase in consumer purchasing power. For many consumers, lower prices can also translate into higher savings rates. However, deflation hurts consumers in the long run as rising rates of unemployment take effect.

2. Impact of Deflation on Businesses

Falling prices that occur from a decline in consumer demand result in slower growth in sales for businesses. Since rising interest rates often accompany deflation, businesses face an increasing debt burden and lower borrowing capacity, potentially leading to defaults on debt or even bankruptcy.

3. Impact of Deflation on Investors

During times of deflation, in addition to falling prices for goods and services, the prices for assets are generally falling. With stocks, bonds, real estate, and commodities falling in value, the relative value of cash is rising. This incentivizes less investment, potentially causing further declines in asset prices.

Historical Examples of Deflation

The two leading examples of deflation in U.S. history occurred during the Great Depression and the Great Recession. Outside of the U.S., another prime example of deflation was Japan’s Lost Decade.

1. The Great Depression: 1929-1933

The most extreme example of deflation in the U.S. occurred in the Great Depression in the 1930s. According to the Federal Reserve Bank of San Francisco, the Consumer Price Index, or CPI, dropped 25% between 1929 and 1933.

2. The Great Recession: 2007-2009

A financial crisis marked by falling GDP, high unemployment, and low consumer confidence, the Great Recession was similar to, although not as severe as, the Great Depression, hence its similar name. From October 2007 to March 2009, the return on the S&P 500 Index was -46%.

3. Japan’s Lost Decade: 1991 – 2001

Japan’s post-World War II economic expansion peaked in the 1980s and entered into a period of deflation and slow growth from about 1991 to 2001. Slow growth extended through 2021, causing some economists to change the lost decade to the plural “lost decades,” as falling consumer prices and slow corporate investment continued to plague Japan.

Deflationary Asset Hedges

While asset prices are generally falling during deflation, some investment types have historically performed better than others in a deflationary environment. For example, some top consumer staples sector stocks, such as Walmart (WMT) had positive returns during the deflation of 2008.

Bonds in the aggregate were also generally positive during the deflation of 2008 because the Federal Reserve was actively lowering interest rates (bond prices and interest rates have an inverse relationship). In some environments, particularly during periods of uncertainty and perceived risk, many investors consider gold to be a safe haven asset.

Note: Past performance is no guarantee of future results. For many investors, diversification and dollar-cost averaging can be a more prudent approach than market timing or making heavy allocations to certain market segments.

Why Is Deflation Bad?

In the short term, falling prices can be good for consumers, as their purchasing power increases. However, on an aggregate level, deflation is bad because it impacts consumers and businesses negatively, especially as unemployment rises and asset prices fall.

While the risk of deflation has not been high in the U.S. since the Great Recession, the economy is particularly vulnerable in today’s low-interest rate environment. With very little “ammunition” in the form of monetary stimulus available to the Federal Reserve, deflation could be potentially difficult to contain.