Most people are familiar with the word inflation, which typically has a negative connotation. However, in economic terms, deflation is actually a worse prospect. In monetary policy, it can refer to the overall shrinkage of the money supply or the decrease in the cost of consumer goods and services. Where inflation means a rise in prices and a drop in purchasing power, deflation indicates a lack of purchasing ability altogether. 

In fact, it’s a form of economic contraction. It signals a depressionary period that can perpetuate even more economic downturn by its very nature. Thankfully, the Federal Reserve can use strategic monetary policy to avoid or combat it. Combating deflation starts by understanding it. Here’s what investors and companies need to know. 

Understand the differenc betwen deflation and inflation

Deflation Correlates With Depression

Looking for historical examples of deflation? The best place to start is with significant stock market crashes and corrections. The Great Depression (1929-1933) was the single biggest period of deflation in United States history. The Great Recession (2007-2009) was another major deflationary period.

The correlation between deflation and depression occurs because they share the same catalysts. Often deflation begets economic depression. Specifically, it’s a cyclical series of events that triggers them: 

  • Lower profits. Declining consumer demand causes sales and revenue to fall, which ultimately lowers the profitability of companies. 
  • Bankruptcy. Lower profits lead to insolvency, which forces businesses to file for bankruptcy.
  • Unemployment. Bankruptcy filings usually come with layoffs and furloughs, which drives up the unemployment rate.
  • Lower income. Unemployed individuals and households have lower incomes and thus, lack of purchasing ability beyond the staples.
  • Lower demand. Lower income leads to fiscal conservancy, which results in less incentive to spend money outside of essentials.

This entire process perpetuates itself, which increases deflation and kickstarts economic depression. This is why it’s so dangerous, and why it’s important to recognize the economic signs and potential signals. 

What Causes Deflation?

What starts the cycle of deflation? The answer is usually a number of different catalysts, but they all share a common factor: contraction. Whether it’s monetary supply or access to capital, where there’s contraction, deflation tends to follow.  

  • Decrease in monetary supply. When people don’t have access to money, they can’t spend it. Likewise, when businesses can’t access capital easily, they’re unable to grow.
  • Decrease in government spending. When government spending contracts, so do all markets benchmarked against it—which is to say, nearly every financial market.
  • Decrease in business investment. Businesses that can’t access capital don’t reinvest it back into the economy, which can drive down profits and productivity.
  • Decrease in consumer demand. As consumer spending drops, demand drops with it, which affects profitability of companies.

Many of these catalysts are the direct result of economic depression. It can be difficult to tell where, exactly, deflation begins and what it causes (or causes it). Did a decrease in consumer demand cause companies to lay off workers, or did the layoffs cause a drop in consumer demand? Deflation illustrates the interconnectedness and complexity of the economy. 

How to Combat

Central banks are instrumental in combating deflation. Specifically, the Federal Reserve can enact monetary policy to increase spending and demand by putting more money into circulation and by controlling interest rates. Some of the strategies the fed will use to prevent deflationary spiral and economic contraction include:

  • Lowering bank reserves to increase monetary supply
  • Quantitative easing, to exercise control over monetary supply
  • Lowering target interest rates to improve access to capital
  • Negative interest rates, to entice borrowing
  • Increased government spending, to improve market confidence
  • Reduced tax rates, to ease financial burdens on companies and consumers

Combating deflation generally comes down to increasing access to cash and giving people the confidence to spend it. Depending on the cause, the fed can pull one or many of these levers to slow and reverse the rate of deflation, to prevent recession or depression. 

Deflation Isn’t Always Bad

Deflation at a macro scale is a bad sign; however, in specific instances, it isn’t necessarily bad. For example, technology has driven down costs in many sectors, making the price of goods and services more affordable. In these situations, price deflation is present while accessibility has gone up. The result has actually driven expansion in the sector as a whole. 

There’s no better example of positive deflation than the cost of data. In 1980, the cost of a single gigabyte of data was $437,500; today, it’s roughly a penny. This massive deflation hasn’t killed the telecom industry—rather, it’s made it broadly accessible to more consumers and driven profitability to new heights. 

How Businesses and Investors Cope

During periods of deflation, businesses need to focus on the balance sheet. That means reducing liabilities and amassing assets. A business’ biggest concern is covering its outstanding liabilities in the face of decreased sales and consumer demand. Cash reserves and minimal debt are strong positions to be in when deflation strikes. 

For investors (and consumers) deflation can be an opportunity—provided your personal finances aren’t affected by job loss or bankruptcy. Falling prices mean an increase in purchasing power. It’s also an opportunity to make smart investments in stable companies. 

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Like inflation, deflation is a tricky subject to navigate and can mean different things based on context. It’s important for businesses and investors alike to understand how periods of deflation affect them—and how to make the most of the situation as monetary policy corrections come into play.