Deflation

What does deflation mean?

Deflation is a general and sustained fall in the price level of goods and services – the opposite of inflation. Money gains purchasing power: the same amount buys more over time. Deflation typically occurs when aggregate demand in an economy is lower than aggregate supply. It should not be confused with disinflation, in which prices are still rising, only more slowly.

How deflation affects the economy

In a deflation, consumers hold back on spending – why buy today if the same product may be cheaper tomorrow? Demand for goods falls while supply stays the same. Companies hold back as well, buying only what is necessary and investing very little. The drop in demand leads to lower sales and profits, which can cause payment difficulties and even insolvencies. Firms then cut jobs and wages, weakening demand further – economists call this a deflationary spiral. Debts also become heavier in real terms: a $100,000 loan still has to be repaid in full even as prices and incomes fall.

Well-known examples are the Great Depression of the 1930s and the long period of falling or stagnating prices in Japan from the late 1990s onwards.

Why deflation matters for traders

Central banks regard persistent deflation as a serious threat and usually respond with a low interest rate policy and other measures to expand the money supply. Signs of deflation, such as negative inflation rates in consumer price data, therefore often point to falling interest rates and bond yields. Shrinking profits tend to weigh on stock indices, while the effect on a currency depends largely on how strongly its central bank is expected to react.