What is deflation?

What is deflation?

Deflation refers to an economic period in which asset prices start falling. In other words, you can now buy more stuff than you used to with the same amount of money. 

Sounds pretty good, right?

Well, not so fast! Falling prices are awful for the economy and might mean you're about to lose your job.

Deflation means a decline in the demand for goods and services. It also creates a feedback loop – people see prices regularly coming down, so they delay making big purchases, expecting a better deal in the future.

And deflation begets deflation. When prices keep falling, companies take in less revenue and can no longer afford to pay their workforce. Unemployment rises, and households have even less money to spend. This causes a further cut back on purchases, resulting in even lower prices and more unemployment (and on and on it goes).

That's the funny thing about money. Deflation sounds good but is actually bad, whereas inflation sounds bad but is relatively good (in moderation).

What are its causes and effects?

Deflation means there is less money supply in the economy, reducing overall demand for goods and services. For example, price deflation occurred during the Great Depression in the United States in the 1930s after significant bank collapses effectively took money out of the economy. Consumers suddenly had less money to spend, which meant they had to reduce their demand for stuff.

But it doesn't just require the collapse of part of the economy to dampen consumer demand. Other factors can limit the amount of money in the economy and decrease aggregate demand – including government spending cuts, higher taxes, a stock market crash, or high interest rates.

Deflation can also happen if the economy over-corrects after a period of high inflation (what economists often refer to ominously as a 'hard landing').

We mentioned earlier that a moderate level of inflation in the economy can be a good thing. It means there is a manageable level of demand for goods and services, and things are ticking along nicely. However, if inflation gets too high, prices rise too quickly, and more people struggle to keep up.

When this happens, the central bank will start hiking rates to constrict spending and reduce demand. But, if the central bank goes too hard or inflation is too stubborn, these rate hikes can push the economy into a recession (or, worse yet, a depression).

This will often lead to price deflation. Money becomes more valuable in the economy because it is more scarce. However, its scarcity necessarily means that fewer people have it, which means higher levels of unemployment and poverty.

But look, it's not entirely doom and gloom. Pockets of the economy can experience price deflation when a productivity breakthrough suddenly results in increased output. This means that supply briefly exceeds demand, pushing prices lower.

Productivity can increase due to better technology, more efficient processes, or new, more innovative (and cheaper to produce) products. So, in some instances, deflation can be a signal of progress.

What does deflation mean for the economy?

Although it should mean more money in your wallet, what deflation signifies about the health of the broader economy is pretty bleak. Essentially, the economy is wheezing and gasping for breath. Its pulse is slowing down.

The economy requires a basic level of demand. It incentivises new products, innovations, and new entrepreneurs and business owners. When demand is at healthy levels, it's impossible to avoid a low level of inflation. But so long as it doesn't get out of control and wage growth can keep up, everything's hunky-dory.

So, when the inflation rate starts to drop to the point where deflation occurs, it usually signals that the economy is unhealthy. It's no longer churning along at its nice low level of inflation anymore – it's starting to go backwards. And, just like sharks, economies aren't great at going backwards. People lose their jobs and living standards decline.

Some examples of deflation

The 1930s Great Depression is probably the most well-known modern example of deflation. It occurred because a series of bank collapses led to a sharp reduction in the monetary supply. This then sparked bankruptcies and rising unemployment, further stifling the economy.

Japan has also experienced deflation on and off since the 90s. Many factors have led to price deflation in Japan, not least of which is an ageing population. Older demographics typically don't spend as much, which has kept demand (and asset prices) low. Even negative interest rates haven't helped to stimulate Japan's economy.

Deflation versus inflation (and disinflation)

Deflation occurs when prices are falling. Inflation is when they are increasing.

As we've already discussed, a healthy economy needs a little inflation. It signifies a healthy level of economic demand for goods and services. More companies are churning out profits, keeping people in jobs.

If inflation gets too high, goods and services become so expensive they are no longer affordable for large portions of the population. This is untenable, so central banks hike interest rates to try and reduce demand, bringing inflation back down within a manageable band (between 2% and 3%, according to the RBA).

So, deflation is when prices decline; inflation is when prices increase… what about disinflation? 

Disinflation is when the rate of inflation declines (in other words, when inflation slows down). So, in disinflation, prices haven't declined versus the prior period, they just haven't increased by as much.

Put another way: bringing inflation back down to within the RBA's manageable band requires disinflation – but too much disinflation results in deflation!

How does deflation impact your share portfolio?

I hate to break it to you, but 'assets' includes shares.

So, when the prices of things come down, so do the prices of shares. People who lose their employment might start selling off any shares they own to cover other expenses, and company profit outlooks will decline due to lower demand, further dampening share prices.

In response, share investors may flee to low-risk assets like bonds or gold. This causes demand for company stock to decline even further – even relative to other assets. It can look like a death spiral – think Black Thursday in October 1929, which heralded the Great Depression in the US.

How to invest in times of deflation

If you're a long-term investor, the best thing you can do is continue investing like you usually would. Hopefully, you can still invest regularly, in which case you shouldn't panic and instead consider this a good buying opportunity. As the economy recovers and prices increase again, the shares you picked up during the deflationary period will start to look like genuine bargains.

However, it's worth recognising that periods of deflation can often cause hardships for households. If you are affected, the best thing you can do is speak to a financial counsellor. Ideally, you can find a way to manage your household expenses without resorting to selling your shares and realising any significant losses.