What Is Deflation?

After the last few years, most people will find themselves all too familiar with the concept of inflation, but what about deflation?

What is deflation? Whilst the clue may be in the name, what’s perhaps less obvious is why deflation is often considered to be worse than inflation. In this article, we will examine both these questions and many more!

What Is Deflation?

Deflation occurs when there is a sustained decrease in the overall price level of goods and services in an economy. Essentially, it is the opposite of inflation and happens when the rate of inflation turns negative.

As a result of prices falling, the purchasing power of money grows over time, as consumers need less money to buy the same goods and services as they did previously.

Whilst this may sound great in theory, in reality, that isn’t necessarily the case. In fact, many economists fear the prospect of sustained deflation more so than inflation, with most policy makers actively targeting a low, stable rate of inflation.

Deflation vs Disinflation

Deflation is not to be confused with disinflation, two terms which are easily confused but which have two distinct meanings. As already mentioned, deflation occurs when prices are falling and is present when the inflation rate turns negative.

Disinflation, on the other hand, happens when prices are rising, but the rate at which they are rising is slowing. For example, if an economy’s inflation rate falls from 5% to 2%, it is experiencing disinflation. Prices are still rising, but not as quickly as they had been.

Causes of Deflation

There are several factors which can cause prices to fall in an economy, let’s take a quick look at each of these.

Decrease in Money Supply

If there is less money in circulation then it follows that the value of money will increase, making goods and services relatively cheaper.

The supply of money in an economy is something which can be influenced by central bank policy. Just as loose monetary policy creates inflationary pressure, tight monetary policy causes deflationary pressure.

Higher interest rates incentivise people to save their money rather than spend it, as well as making borrowing less attractive due to its higher cost. With more money sitting in banks and less borrowing, the amount of money in circulation will fall.

This is exactly why policy makers hike interest rates when inflation gets too high, they want the subsequent deflationary pressure to bring prices back under control. However, once inflation falls back to target levels, policy then needs to be adjusted accordingly to avoid the risk of inflation turning negative.

Increase in Aggregate Supply

The other two causes of falling prices arise from either the supply-side or demand-side of the economy.

On the supply-side, an increase in the aggregate supply of goods and services can lead to a fall in the general price level. This can occur when technological advances lead to increased efficiency and a subsequent increase in productivity, with cost savings being passed onto the consumer.

Deflation of this type is sometimes referred to as benign deflation. It is typically viewed as less problematic than deflation arising from the demand-side of the economy, as the fall in price is brought about by increased productivity, which should benefit the economy in the long-run.

Decrease in Aggregate Demand

Deflation can also occur due to a fall in aggregate demand. Besides tighter monetary policy, the effects of which we examined earlier, a decrease in demand may also be the result of a drop in consumer confidence or a reduction in the availability of loans (a “credit crunch”).

A fall in aggregate demand is likely to result in businesses dropping prices for goods and services in an attempt to reignite consumption. If prolonged, lower prices and lower demand can lead to falling profits and rising unemployment, as demand for labour decreases.

Why Is Deflation Bad?

As consumers, it may seem counterintuitive to suggest that falling prices can be a bad thing. Lower prices would allow consumers to buy more, which should surely benefit everybody. Whilst a brief period of transitory deflation may well be beneficial, entrenched deflation can be more problematic.

A sustained period of falling prices will result in businesses making less money for selling the same amount of goods and services. The resultant decrease in profits is likely to result in cost cutting measures, such as job cuts. The consequential increase in unemployment would lead to a further reduction in demand, as laid off workers are forced to cut their spending habits, thus reinforcing downward pressure on prices.

Furthermore, falling prices may result in consumers delaying non-essential purchases in the hope that prices will be even lower in the future. Imagine you wanted to buy something but thought that, if you waited a few weeks, it would be cheaper. Would you be tempted to delay the purchase?

Again, this type of behaviour from consumers can reinforce downward pressure on prices, as demand falls further. The fear amongst policy makers is that rising unemployment, falling wages and tumbling demand could lead to a deflationary spiral, with the consequences of deflation fuelling further deflation.

The Effect on Debt

Something else to bear in mind is the effect that deflation has on existing debt.

As prices fall, the purchasing power of money increases, meaning that, in real terms, the value of money is growing. The result of this is that existing debt becomes more expensive to service in real terms, which will negatively impact anyone who has debt, including the government.

If deflation becomes entrenched, existing debt will get more and more expensive to service which is likely to lead to an increase in defaults. As the amount of bad debt increases, lenders may become increasingly tentative about extending credit, something which can ultimately breed further deflation.

Is Deflation Worse Than Inflation?

Central banks tend to fear deflation more than inflation, which is evidenced by policy makers actively targeting an inflation rate of around 2%.

Inflation, at this level, is generally accepted to bring benefits to an economy. It encourages a certain level of consumption, as money sitting in the bank is slowly losing value. This maintains demand in the economy which, in turn, sustains employment levels and encourages economic growth.

Whereas a low, stable rate of inflation is typically viewed as beneficial for an economy, deflation is generally seen as negative, particularly because it can be difficult to recover from, as demonstrated by deflation in Japan throughout the 1990s.

The negative consequences of deflation cause concern for central banks, as they can lead to a contraction in economic output and potentially tip an economy into recession.

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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.