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.)

Related Articles
  1. Mutual Funds & ETFs

    ETF Analysis: PowerShares DB US Dollar

    Discover how an ETF can be used to bet on multiple different currency futures contracts with the PowerShares DB Dollar Index Bullish Fund (UUP).
  2. Fundamental Analysis

    Should You Invest Your Entire Portfolio In Stocks?

    It is true that stocks outperform bonds and cash in the long run, but that statistic doesn't tell the whole story.
  3. Options & Futures

    The Consumer Price Index: A Friend To Investors

    As a measure of inflation, this index can help you make key financial decisions.
  4. Bonds & Fixed Income

    The Money Market: A Look Back

    Learn how past inflationary periods can predict future real rates of return for cash investments.
  5. Investing

    Time to Bring Active Back into a Portfolio?

    While stocks have rallied since the economic recovery in 2009, many active portfolio managers have struggled to deliver investor returns in excess.
  6. Mutual Funds & ETFs

    The Democratization of the Hedge Fund Industry

    The coveted compensations of hedge fund managers are protected by barriers of entry to the industry, but one recent startup is working to break those barriers.
  7. Investing Basics

    Why Interest Rates Affect Everyone

    Learn why interest rates are one of the most important economic variables and how every individual and business is affected by rate changes.
  8. Economics

    Investing Opportunities as Central Banks Diverge

    After the Paris attacks investors are focusing on central bank policy and its potential for divergence: tightened by the Fed while the ECB pursues easing.
  9. Professionals

    A Day in the Life of a Hedge Fund Manager

    Learn what a typical early morning to late evening workday for a hedge fund manager consists of and looks like from beginning to end.
  10. Investing

    The Hunger Games Economy: 5 Unanswered Questions About Panem

    The Hunger Games's fictitious nation of Panem has technology, black markets, and government. But, we know precious little about Panem's economy and the reasons for its rampant inequality.
  1. What is the correlation between money supply and GDP?

    It is difficult to measure the money supply, but most economists use the Federal Reserve's aggregates known as M1 and M2. ... Read Full Answer >>
  2. Were there any periods of major deflation in U.S. history?

    In historical contexts, the second half of the 20th century in the United States was unique because of how little deflation ... Read Full Answer >>
  3. How does aggregate demand affect price level?

    Prices coordinate supply and demand, and they are also determined by it; there is no clean, direct and one-dimensional link ... Read Full Answer >>
  4. How were nominal interest rates in the economy set before the Federal Reserve?

    Interest rates – especially nominal interest rates – are ultimately decided by individual preferences for liquidity and current ... Read Full Answer >>
  5. Can hedge funds trade penny stocks?

    Hedge funds can trade penny stocks. In fact, hedge funds can trade in just about any type of security, including medium- ... Read Full Answer >>
  6. Are hedge funds regulated by FINRA?

    Alternative investment vehicles such as hedge funds offer investors a wider range of possibilities due to certain exceptions ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Take A Bath

    A slang term referring to the situation of an investor who has experienced a large loss from an investment or speculative ...
  2. Black Friday

    1. A day of stock market catastrophe. Originally, September 24, 1869, was deemed Black Friday. The crash was sparked by gold ...
  3. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  4. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  5. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  6. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
Trading Center