Deflation, in simple terms, is erosion in the prices of products and services by way of reduced demand. It can spiral even further, as businesses chase that limited demand with even lower prices. For the consumer, the lower prices may seem like a benefit, especially following a period of prolonged inflation or when wages are stagnant or falling.
In a deflationary environment, those who have borrowed funds from lending institutions are now reluctant (or unable) to repay the money they borrowed. Also, stocks, bonds and real estate that would not be in the market during an inflationary environment may be unloaded below actual value. For this reason, the Federal Reserve Board wages a constant battle against inflation using monetary policy, with the fear of deflation in mind. (To learn more, read Formulating Monetary Policy.)
Deflation Over Time
The last time the U.S. economy suffered from a prolonged deflationary period was during the Great Depression. The economy experienced textbook deflation with a dramatic drop in output and price levels. During the period from 1928-1933, U.S. GDP fell each year and, as there is a global link to the U.S. economy, other countries experienced similar drops. Canada and Germany also experienced their own forms of deflation. Since this time, there have only been brief periods of declining price periods in the U.S., and they were not universally accepted as systemically deflationary (the next sustained deflationary period was experienced by Japan in the 1990s). (To learn more, read What Caused The Great Depression.)
Lack of Data
Deflation carries with it a bad stigma, and most likely haunts the Federal Reserve every time a change in the direction of interest rates is made. One of the major issues with the theories of the negative impact of deflation is that there really isn't much historical data on the subject (outside of the Depression era) to study. Empirical studies lend considerably more credence when they are based on long-term periods with multiple observations of events to study. With only one substantial deflationary period in modern history, it is very easy to consider the potential positive effects of deflation.
Not All Deflations Are Bad
Consider this hypothetical, yet feasible, case: the economy experiences a prolonged period of exponential technological innovations - an intense price competition led by low-price retailers and, subsequently, a prolonged period of cheap capital to leverage and relatively loose lending standards. This scenario could lead to a sustained rise in the supply of goods as they become cheaper to manufacture, and an oversupply of products available to consumers as well as those who supply them. Taking just that information, this deflationary situation looks good for consumers: cheaper products, more variety and more providers to serve them. This brings us back to the inability to study deflationary periods in modern times, and can even suggest that the deflation experienced during the Depression may have been an anomaly.
Periods of Falling Prices
The fears of deflation are often confused with temporary declining prices. While deflation is characterized by a sustained aggregate fall in the combined index of Consumer Price Index (CPI) or gross domestic product, (GDP) deflator, the U.S. economy is so much more complex than it was in the 1920s and 1930s. There are outside influences on core commodities that move prices and stay unnaturally low or high. Global demand for resources is also in limited demand; hedge funds, wars and trends in demand can all put pressure on one commodity that can affect the entire economy. This is what makes deflation hard to predict, difficult to define and almost impossible to verify until it has set in or almost passed. It also makes it difficult to determine if it is, in fact, all bad. (To learn more about CPI, read The Consumer Price Index: A Friend To Investors.)
The consensus among policymakers and economists is that the threat alone of deflation is a concern. And the limited amount of data available to study, and the somewhat ambiguous nature of deflation itself, are only a couple of the hurdles involved with studying its effects. It's possible that, like a swinging pendulum, a deflationary environment pauses briefly before swinging the other way. This may be why there is such a large gap between deflationary periods and also may explain why they seem nonexistent these days. Or maybe policymakers have simply been doing an excellent job in deterring the cycle. Either way, it's possible that some deflation may be a normal part of our economic cycle, and is not always such a bad thing. (For related reading, see Recession And Depression: They Aren't So Bad.)